MODULE-I: MANAGERIAL ECONOMICS

1.1 Introduction
Economics is the study about making choices in the presence of scarcity. The notions, ‘Scarcity’ and ‘Choice’ are very important in Economics. If the things were available in plenty then there would have been no choice problem, you can have anything you want. The point is that problem of choice arises because of scarcity. The study of such choice problem at the individual, social, national and international level is what Economics is about. Thus, Economics as a social science, studies the human behaviour as relationship between numerous wants and scarce means having alternative uses. Economics, as a basic discipline, is useful for certain functional areas of business management. Economics could be broadly classified into two categories: 1) Macro economics and 2) Micro economics. Macroeconomics is the study of the economic system as a whole. Microeconomics, on the other hand, focuses on the behaviour of the individual economic activity, firms and individuals and their interaction in markets. Managerial economics is an applied microeconomics. It bridges the gap between abstract theories of economics in the managerial decision-making. So, managerial economics is an application of that part of microeconomics, focusing on those topics of the greatest interest and importance to managers. The topics include demand, demand forecasting, production, cost, cost function, pricing, market structure and government regulation. A strong grasp of the principles that govern the economic behaviour of firms and individuals is an important managerial talent. In general, managerial economics can be used by the goal-oriented manager in two ways. First, given an existing economic environment, the principles of managerial economics provide a framework for evaluating whether resources are allocated being efficient within a firm. For example, economist can help the management to determine if reallocating labour from marketing activity to the production line could increase profit. Second these principles help managers respond to various economic signals. For example, given an increase in price of output or development of new lower cost production technology, the appropriate managerial response would be to increase output.

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Alternatively, an increase in the price of one input, say labour, may be a signal to substitute other inputs, such as capital, for labour in production process.

1.2 Meaning and Definition of Managerial Economics
Managerial Economics is the application of economic theory and methodology to decision-making processes within the enterprise.  Hailstones and Rothwell defined managerial Economics as “Managerial Economics is the application of economic theory and analysis to practices of business firms and other institutions.”  According to McNair and Merian say that “managerial economics consists of the use of economic modes of thought to analyze business situations”.  Spencer and Siegelman defined Managerial Economics as “the integration of economic theory with business practice for the purpose of facilitating decisionmaking and forward planning by the management”.  According to Prof.Evan J.Douglas “Managerial Economics is concerned with the application of economic principles and methodologies to the decision making process within the firm or organization under the conditions of uncertainties”  In general, Managerial Economics could be defined as the discipline which deals with the application of economic theory to business management.

1.3. Nature of Managerial Economics
Management is the guidance, leadership and control of the efforts of a group of people towards some common objective. It tells about the purpose or function of management. Koontz and O’ Donell define management as the creation and maintenance of an internal environment in an enterprise where individuals work together in groups, can perform efficiently and effectively towards the attainment of group goals. Thus, management is coordination, an art of getting things done by other people. On the other hand, economics due to scarcity of resources is primarily engaged in analyzing and

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providing answers to the various basic economic problems like what to produce? How to produce? And for whom to produce? Science of Economics has developed several concepts and analytical tools to deal with the problem of allocation of scarce resource among competing ends. Close interrelationship between management objectives and economic principles has led to the development of Managerial Economics. Managerial Economics as a link between economic theory and decision science, its purpose is to contribute to sound decision making not only in business but also in government agencies and Non- profit organizations. In particular, managerial economics assists in making decisions about the optimum allocation of scarce resources among competing activities. The following chart shows the nature of Managerial Economics.

Economics
Tools and Techniques

Business Management
Choosing the best alternative

Managerial Economics
Application of Economics to Solve business problems

SOUND BUSINESS DECISION

1.4. Scope of Managerial Economics
Scope of the subject is said to be an extent of coverage of the subject concerned or boundaries within which subject is set in and also the importance of the subject. Managerial Economics, among others, embraces following important aspects.   Demand Analysis and Forecasting Production and Cost Analysis

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3 Pricing Decisions. 1. Production function and cost analysis enable the firms to achieve these goals. The price policy of the firms determines its sales volume as well as its revenue. 1.4. business firms are forced to produce goods and services with cost effectiveness. Input-output analysis. Demand analysis helps identify the various factors influencing the demand for firm’s product and thus provides guidelines to manipulating demand. In case the prices of inputs shoot up. 1.   Pricing Decisions. and services that are to be sold in a market. are also become the part of the subject.2 Production and Cost Analysis In the competitive environment.4. is necessary for business planning and occupies a strategic place in Managerial Economics. combined with the data drawn from the firm’s accounting records can yield significant cost estimates that are useful for managerial decisions. Policies and Practices Capital Management.4. therefore. in the recent years some of the techniques like Linear Programming. a major part of managerial decision-making depends on accurate analysis of demand. The factors of production may be combined in a particular way to yield maximum output. a study of economic costs. Price X Sales volume = Gross Revenue of the firm 4 . etc. Policies and Practices The success of a business firm mainly depends on the sound price policy of the firm.1 Demand Analysis and Forecasting Demand is a starting force for any business firm to emerge. Demand analysis and forecasting. A business firm is an economic organism. Along with the above. So. Hence. a firm is forced to work out a least cost combination of inputs in producing a particular level of output. which transforms productive resources into goods. The suitable strategy for the minimization of cost could be evolved. and Profit Management Though the above ones are treated as subject matter of Managerial Economics.

Profit policies. It is to be managed more efficiently for the overall development of the economy as well as for the prosperity of the firm. Managerial Economics and its Relationship with Other Disciplines Managerial Economics is an interdisciplinary course. A firm’s capital management is most troublesome and complex activity of business management.4. An element of risk deserves place at this point. 1. Differential pricing. 1. Product line pricing and so on. Managerial Economics is application of economic principles and concepts towards adjusting with various uncertainties faced by a business firm. The important aspects covered under this are: Nature and measurement of profit. Important aspects dealt with under this area are: Price and output determination in various Market forms. Mathematics. which a business firm has to reckon with. 5 . Managerial economics is linked with various other fields of study. However. Profit analysis becomes an easy task in the absence of risk.5 Profit Management All kinds of business firms generally organized for the purpose of making profits. Rate of return and selection of projects. In the long-run profits provide the chief measure of success. The above-mentioned aspects represent the major uncertainties. pricing is very important area of Managerial Economics.4. the relation of Managerial Economics is not confined only to them. 1. Statistics. In developing countries like India it is a limiting factor on the economic development.4 Capital Management Capital is one of the most important factors of production. pricing methods.5. Thus. The major areas dealt here are: Cost of capital. In fact most of the management courses are of that sort. However in the business it is difficult to assume something without risk. Subjects like Economics.Therefore. This kind of capital management implies planning and control of capital expenditure. and Accounting deserve greater emphasis in this regard.

1. The modern theory of income and employment has direct implications for forecasting general business conditions. Input-output analysis is also very much 6 . Vectors and so on are the tool kits of managerial economists. Operations Research is also closely related to Managerial Economics. Similarly statistics is also useful in the estimation of production and cost functions. In this way Managerial Economics is heavily rely on statistical methods. application of statistics in Managerial Economics helps in decision-making in several ways. used to find out the best of all possibilities. production function etc. Managerial economics in particular deals with quantifiable variables. marketing forms. It may be viewed as a special branch of economics. Thus.5. calculus and matrix-algebra is not only essential but certain mathematical concepts and tools such as Logarithms and Exponentials. it is felt that the roots of managerial economics spring from micro-economic theory.3 Managerial Economics and Mathematics: Mathematics is another important discipline closely related to Managerial Economics.1. are of great significance to managerial economists. It is again because managerial economics is quantifiable.1 Managerial Economics and Economics: Managerial Economics is widely understood as economics applied to managerial decisions. functioning as bridge between economic theory and managerial decisions.5. Knowledge of geometry. Therefore. The chief contribution of macroeconomics is in the area of forecasting of general business conditions. In addition. distribution of commodities and optimum product mix etc. elasticity of production. It helps in the estimation of demand function. is main source of concepts and analytical tools for managerial economists. Microeconomics. To illustrate. which in turn helps in demand forecasting.5. Estimation of price index relays heavily on statistical tools.2 Managerial Economics and Statistics: Economics in general. demand forecasting. one of the main divisions of economics. Linear Programming is an important tool for decision-making in business and industry as it can help in solving problems like determination of facilities on machine scheduling. 1. Quantification and estimations plays crucial role in managerial economics. concepts such as elasticity of demand.

These basic concepts or principles are fundamental to the entire gamut of managerial economics. 3. there is close relationship between Managerial economics and Mathematics. 1. which can be of considerable assistance to the manager in his/her decision-making process. 5. The main task of the management accountants now seen as being to provide the sort of data which manager needs if they are to apply the ideas of managerial economists to solve the business problem. Opportunity cost principle 2. it is the application of economic theory to management decision-making. 4.1 Opportunity Cost Principle Opportunity cost is of fundamental importance in decision-making process. 1. The basic concepts discussed in this section includes: 1. If there are no 7 . For example. Economic theory offers a variety of concepts and analytical tools. The opportunity cost principle may be stated as under: The cost involved in any decision consists of the sacrifices of alternatives required by that decision. Thus. Incremental principle Time perspective principle Discounting principle Equi-marginal principle 1.6. the profit and loss account of a firm tells how well the firm has done and the information it contains can be used by a managerial economist to throw light on the present economic performance of the firm and future course of action. Some important basic concepts are discussed in this section. Fundamental Concepts of Managerial Economics Managerial Economics as explained earlier. It is in this context that the growing link between management accounting and managerial economics deserve special mention.4 Managerial Economics and Accounting: Accounting mainly deals with systematic recording of the financial reports of business firms.useful in managerial economics.5. As a matter of fact accounting information is one of the principle source of data required by a managerial economist for his decision making purpose.6.

otherwise not. Decision implies making a choice from among the various alternatives. a businessman invests his own capital in business. Another illustration. By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. Thus. (1) Production of X commodity (2) Total Revenue (3) Incremental Revenue (4) Total Cost (5) Incremental Cost (6) Total profit 7=(3-6) 1 2 3 1000 2000 3000 20000 39500 58500 19500 19000 18000 37000 58500 19000 21500 2000 2500 0 8 . the opportunity cost may be measured in terms of salaries he could have earned from some employment from elsewhere. The two basic components of incremental reasoning are incremental cost and incremental revenue. Table 1: Revenue and Cost of X Commodity Pertaining to ABC Company Sl. Incremental cost may be defined as the change in the total cost due to particular decision. there is no cost. Thus. businessman compares expected rate of return (prospective yields) from business with current rate of interest/salary and if he finds that prospective yields happen to be greater than the rate of interest/salary he would take a positive decision for further investment. when incremental revenue exceeds incremental cost resulting from a particular decision. For example. opportunity cost is the benefit foregone by not selecting the best alternative. Incremental revenue is the change in total revenue caused by particular decision. The incremental concept refers to the change in total.2 Incremental Principle The concept of incremental principle is related to the marginal costs and marginal revenues concepts of economics. Thus. which he could have earned by lending that money to somebody.sacrifices. This certainly helps arriving at a better decision comparing between incremental costs and revenues of alternative decisions. 1. its opportunity cost can be measured in terms of interest. No. For example table 1 illustrates the revenue and cost of producing commodity ‘X’ by ABC Company. A decision is cost free if it involves no sacrifice. in above cases.6. it is regarded as profitable. It involves estimating the impact of decision alternatives on cost and revenues. when a businessman devotes his time in organizing his business.

an optimum allocation has not been 9 . Thus.6. Suppose a firm has 100 units of labour at its disposal. Important problem in decision-making is to maintain the right balance between short-run and long-run considerations. which need services of labour viz. 1.3 Time Perspective Principle The economic concepts like short-run and long-run are part of every day language. it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible” 1.1000 is less after two years than it is available today.Increase in production from 1000 units to 2000 units results higher incremental revenue (Rs. an input should be so allocated that the value added by the last unit is the same in all uses. 1. This time perspective of short and long-run period is important in business decision-making. and C. It could enhance any of these activities by adding more of labour only at the cost of other activity. In business decision-making process. as the present value of Rs. The firm engages in three economic activities.19500) compared to incremental cost (Rs.21500) is more than the incremental revenue (Rs. A.6.5 Equi-Marginal Principle Equi-marginal principle deals with the allocation of the available resources among the alternative activities. thus.19000) when the producer increases his production from 2000 units to 3000 units. According to this principle.4 Discounting Principle The concept of discounting is applied to future costs and returns as there are variations in the time perspective underlying different decisions. A simple example would make this point clear.1000 now or after two years. Suppose a person is offered a choice to have Rs. Discounting originates from the concept of opportunity cost and time perspective. It should be clear that if the marginal value product is higher in one activity than another. Therefore. Incremental cost (Rs. He/She would be obviously choosing the first one. B. it is advisable to increase production from 1000 units to 2000 units. the discounting principle may be stated as: “If decision affects costs and revenues at future dates. Managerial economists are also concerned with long and short – run effects of decisions on revenues as well as costs.6.19000).

In other words Net Income = Total Revenue –Total Cost. c are three activities. Long run survival 3. 1.7. Thus. Sales maximization with Profit constraint 4. Rothdchild expressed that the primary objective of any business enterprise is long run survival. For the long run survival to some extent firms compromise with their profit level. K. It would therefore. a.7. in the modern days. Long Run Survival: Economists. 1. do not accept that profit maximisation is the only objective to be attained by the firm. The Net Income is the residual income. It is considered to be the acid test of the performance of the individual firm. Emphasis has been given to this objective in conventional economics. In modern society. however. Profit maximization 2. b.7. very few experts will argue that a firm is motivated by the sole objective of maximization of profit. Objectives of the Firm Each and every business firm strives to achieve some predetermined objectives. The optimum allocation of labour could be ensured when: (VMPL)a = (VMPL) b = (VMPL)c Here. VMPL refers to the value of marginal product of labour. 1.attained.2. Cost minimization 1. this principle is greatly useful in the allocation of any of the resources among alternative uses.1. be profitable to shift labour from low marginal value product activity to higher marginal value product activity. In the 10 . Profit Maximisation: The success of any business is measured by the volume of its net income. which accrues to a firm after all other costs have been met. In the modern days a firm invariably pursues multiple objectives even though one or some of them may receive priority over others. The objectives of the modern firm could be summarized under the following headings. In the conventional economics emphasis was given to the profit maximization objective.

Sales maximisation does not mean an attempt to get largest possible physical volume of output. which the firm 11 . To maintain costumers good will. To maintain pleasant working condition etc. Sales Maximization with Profit Constraint: Prof. American economist. firms’ aims at limited instead of maximum profit for various reasons.3. the objective of a modern firm is sales maximisation with a profit constraint.1: Sales maximization with Profit constraint In this figure X-axis measures the output and Y-axis measures the Total Revenue (TR).modern days. 1. Baumol.1. sales maximisation refers to the maximisation of the total revenue that measures the quantity of product sold in Rupee terms. Total Cost (TC) and Total Profit (TP). Hence. William J. 1. Figure 1. According to him.7. Here the sales means the revenue earned by selling the product. To keep market control undiluted 4. Professor Joel Dean mentioned some of the reasons for limiting profits viz.1. does not agree with the traditional view that firms aims at maximizing profit.To discourage the potential competitors. OM is the minimum profit. 3. 2. It could be presented with the Support of the figure No.

along with quantity of the commodity sold. Economic factors 2. 1.4. Total revenue. depends on the market price of the commodity. It maximizes the total revenue subjected to minimum profit shown by ML curve. With the increase in the output/sales level the TR goes on increasing up to a certain extent then start falling. Human and behavioral factors 3. According to Baumol the firm produce/sell OB amount of output.7. The cost minimization enables the firm to achieve the objectives discussed above. Cost minimization through the existing technical efficiency is within the control of the firm. Therefore.intends to earn. which have equal impact on the choices and decisions of managers. BE is the profit earned by the firm at OB level of output. TP is the difference between the TR and TC. the major factors affecting managerial decisions are: 1. Similarly TC goes on increasing with the increase in the sales level. Technological factors. Cost Minimization: Whether a firm is pursuing the profit maximisation goal or total revenue maximisation subjected to profit constraint goal or even long run survival goal the firm has to produce the goods or render the service at the least cost through the achievement of the technical efficiency. 1. At OC level of output profit level (CG) is less than intended level (CP). which is many a time beyond the control of the firm. hence TP is the vertical distance between the TR and TC. On the other hand if the firm intends to maximize the sales it has to produce and sell OC amount of the commodity because TR curve maximum at point R2. If the firm intends to get maximum profit it has to produce/ sale OA quantity of output because TP curve is maximum at point H. at the same time it is important to remember three other variables. Undoubtedly economic analysis contributes a great deal to the problem solving in an enterprise. and 4. Environmental factors 12 .8 Factors Affecting Managerial Decisions Managerial decision-making is not just only influenced by economics but also by various other significant factors.

1. It functions amidst of turbulent environment consists of socio-economic. physical.1 Economic Factors Economic factor works as backbone for every decision-making particularly. However. In business organizations for the purpose of survival and growth more than anything economic factors like. This is applicable for new establishment. Environmental pressures operating on the enterprise have a bearing on managerial decisions even when they are primarily economic in nature.8. Yet many of them decide to remain small since they feel that such expansion will tend to strain their lifestyles or threaten their control over the management. 1. who refuse to expand or diversify their economic activity even though economic rational provides clear signal of the opportunities ahead that await them.1.8. So.8.In the present day situation it is even extended to notfor-profit organizations. profit maximization and/or sales revenue maximization play vital role. No major investment decision is made without a close scrutiny of relevant technological alternatives. economic rationality may not hold well all the times. expansion of an existing concern. Ultimately economics is for the well-being of people concerned.3 Technological Factors Technological factors also play crucial role in managerial decision-making process. management of any organization will look into their personal comfort as well employees morale and motivation. In the resource allocation process management of an organization will assess the technological alternatives. It can be observed with small entrepreneurs. in case of commercial organizations .2 Human and Behavioral Factors It is proved beyond the doubt that economic factors occupy significant place in decision-making process.8. the technological moves of competitors and emergence of new technologies and processes. economic 13 .4 Environmental Factors It is impossible to imagine any business organization in isolation. For example. modernization and diversification decisions. 1. political forces etc.

Discuss the objectives of a modern business firm. Sultan Chand & Sons. Self Review Questions 1. Define opportunity cost? Explain its applications in management decisions. Samuel Paul.Mithani : “Managerial Economics: Theory and Applications”.9. Explain the factors influencing the managerial decisions. 5. Explain the importance of incremental principle in the management science. 1. Himalaya Publishing House. and Maheshwari K. 1. D.G. Politicians. Statistics and Accounting.rationality might suggest a strong case for a price rise and yet the organization might be forced by political. Mumbai-400 004 6. New Delhi-110002 2. D. 3. 8. Varshney RL. References/ Suggested Readings 1. community organizations and so on are increasingly concerned about the nature and consequences of these decisions and constantly make their presence felt which may conflict with the economic rationality. Describe the importance of equi-marginal principle in Managerial decision making process. social hostility not to do the same.: “ A Study in Managerial Economics” Himalaya Publishing House. Define Managerial Economics and discuss its nature and scope. Mumbai-400 004 14 . 4.L: “Managerial Economics”. V. 2. Public awareness about the impact of firm level decisions on society is growing.M. L. Gupta. In the recent times the force of environmental considerations is growing stronger. consumer activists. Mathematics. S: “ Managerial Economics: Concepts and Cases”.10.. 6. “Managerial Economics is economics applied to decision-making” Explain. 7. Gopalakrishna. New Delhi 3. Mote. Explain how managerial economics is related to Economics. Tata McGraw-Hill Publishing Company Limited.

Desires come and vanish.1 Introduction The success or failure of a business depends primarily on its ability to generate revenues by satisfying the demand of consumers. ability to buy and two. Demand.2 Meaning of Demand. It is. Thus.   It is useful technique for demand forecasting with greater reliability. types. elasticity of demand and demand forecasting are discussed in this chapter. demand functions. A desire to be called demand should be backed by two things. In another way the demand for a product could be defined as the amount of it.MODULE-II: DEMAND ANALYSIS AND FORECASTING 2. one. The concept of Individual demand. It gives direction for demand manipulation through advertising and sales promotion strategies. versus change in demand. But desire of a beggar to travel by air could not be materialized for lack of his ability to pay. willingness to buy. Demand = Desire + Ability to pay (purchasing power) + Willingness to pay. ordinarily. Meaning. the demand for any commodity is the desire for that commodity backed by willingness as well as ability to pay for it and is always defined with reference to a particular time and at given price. worthwhile to understand some of the concepts related to demand analysis. determinants of demand. So all such desires could not be considered as demand. is defined as desire. It is not out of context to introduce some of the concepts pertaining to the concept demand. It serves the following managerial objectives. 2. and change in quantity demand 15 . therefore. Demand analysis is a source of many useful insights for business decision-making. Firms that are failed to attract the consumers are soon forced to be out of the business.   It helps in product planning and product improvement. It reveals the scope of business expansion. the law of demand. which will be bought per unit of time at a particular price. Market demand.

2.2.1 Individual Demand and Market Demand An individual demand refers to, other things remaining the same, the quantity of a commodity demanded by an individual consumer at various prices. Market demand is the summation of demand for a good by all individual buyers in the market. The distinction between individual demand and market demand has been explained with the help of individual and market demand schedule as well as demand curves. Tab-2.1:Individual Demand Schedule Fig 2.1 Individual Demand Curve Price (Rs.) 6 5 4 3 2 1 Quantity demanded (units) 10 20 30 40 60 80
7 6 5 4 3 2 1 0 0 20 40 60 80 100 Quantity Dem and

An individual demand refers to the quantity of a commodity demanded by an individual consumer at various prices, other things remaining same. An individual’s demand for a commodity is shown on the demand schedule (Table-2.1) and demand curve (Fig 2.1). A demand schedule is a list of prices and quantities and its graphical representation is demand curve. It could be seen from the demand schedule that as the price of the commodity goes on declining the quantity demand goes on increasing. Only 10 units of commodity are demanded when the price is Rs. 6 per unit whereas the quantity demand increased to 80 units when the price declined to Rs.1 per unit. DD1, in figure 2.1, is the demand curve drawn on the basis of the above demand schedule. The dotted points D, Q, R, S, T and U are the ‘demand points’. They show the various pricequantity combinations. The demand curve shows the effect of rise or fall in the price of one commodity on the consumer’s behaviour. In a market, there will be many consumers for a commodity. Therefore, Market demand shows the sum total of various quantities demanded by all the individuals at

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Price

various prices. The market demand of a commodity is depicted on a demand schedule and demand curve. Suppose there are three individuals A, B, and C in a market who purchase the commodity. The demand schedule for commodity is depicted in table-2.2. The column 5 of the table represents the market demand for the commodity at various prices. It is obtained by adding the column 2, 3 and 4 which represent the demand of the consumers A, B and C respectively. The relation between column 1and 5 shows the market demand schedule. Table 2.2 Market Demand for the X Commodity Price (Rs./Kg) Consumer A (1) 6 5 4 3 2 1 (2) 10 20 30 40 60 80 Quantity demand in Kgs. Consumer B Consumer C (3) 20 40 60 80 100 120 (4) 40 60 80 100 120 160 Market Demand (5) (2+3+4) 70 120 170 220 280 360

The market demand for the commodity at the price level of Rs.6 per unit is 70 Kg. The market demand increased to 360 Kg with the fall in the price to Rs.1 per Kg. In the figure 2.2, Dm is the market demand. It is the horizontal summation of all the individual demand curves DA+DB+DC. The market demand for a commodity depends on all factors that determine an individual demand. 2.2.2. The Law of Demand The law of demand describes the general tendency of consumers’ behaviour in demanding a commodity in relation to the change in its price. The law of demand simply states that the quantity demand of a commodity varies inversely to change in price. “Ceteris paribus, the higher the price of a commodity, the smaller is the quantity demand and lower the price, larger the quantity demand”. The law of demand relates the change in quantity of demand to the change in the price variable only. It is always stated with the ceteris paribus i.e other things remaining same. It assumes other

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determinants of demand to be constant. Thus the law of demand based on, among others, the following major assumptions:     No change in the price of related goods No change in the consumers income No change in the consumers preference No change in the advertisement strategies of business houses Figure 2.2: Market Demand Curve

It is almost a universal phenomenon of the law of demand that the demand curve slopes downward from left to right. In certain cases demand curve may slopes up from left to right. It is because consumer may buy more when the price of a commodity rises and less when price falls. Such circumstances are termed as exceptions to law of demand. Exceptional cases may be categorized as; 1.Giffen found that in the 19th century, Ireland people were so poor that they spent a major part of their income on Potatoes and small part on meat. For them potatoes and meat are inferior and superior goods respectively. When price of potatoes rose, they had to economise on meat even to maintain the same consumption of potatoes. Further to fill up the resulting gap in food supply caused by a reduction in meat consumption, more

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their snob appeal increases and they are purchased in large quantity and vis-à-vis. demand extends when the price falls and it contracts when the price rises.2. 2. 3. a fall in price is frequently followed by smaller purchase and a rise in price by larger purchases. When price of certain goods rises. or ‘contraction’ of demand which are quite distinct from the term ‘increase or decrease in demand. The term extension and contraction are technically used in stating the law of demand. The phrase ‘Change in quantity demand’ essentially implies variation in demand referring to ‘extension. Fig. Figure 2. When the price of such goods rises. In the speculative market. which they yield. there is a contraction of demand.3: Extension and Contraction of Demand 19 . people may expect further rise and rush to buy. Such goods are called Veblen goods. but for the impression. Similarly. Thorstein Veblen. It is named after an American economist. Thus the rise in the price of potatoes increased the demand for potatoes. when a lesser quantity is demanded with a rise in price. When price fall.3. they may wait for further falls. Extension and Contraction of Demand A movement along a demand curve takes place when there is a change in the quantity demand due to change in the commodity’s own price. A. and stop buying. Such goods are popularly known as Giffen goods. The extension of demand refers to a situation when more of a commodity is bought with the fall in the price. In short. 2. Some goods are purchased mainly for their snob appeal. which they made on other people. Change in Quantity Demand versus Change in Demand The movement along the demand curve measures the change in quantity demand in relation to the change in price while change in demand is reflected through shift in demand curve.3 illustrates the extension and contraction of demand.2. who advocated that some purchases were made not for the direct satisfaction.potatoes had to be purchased because potatoes were still the cheapest food.

When the price is OP1.3: Increase in Demand (A) and Decrease in Demand (B) 20 . It really means that more is now demanded than before at each and every price. Thus. This is known as extension in demand. This is known as contraction in demand. the quantity demand is OQ1. then a rise in the price from OP2 to OP1 leads to a fall in the quantity demand from OQ2 to OQ1.3A and B respectively. With the fall in price to OP2 the quantity demand rises to OQ2. thus. On the contrary.3 D1D1 is the demand curve. An increase in demand signifies either more will be demanded at a given price or same quantity will be demanded at higher price. B. 2. The terms increase and decrease in demand are graphically expressed by the movement from one demand curve to another in figure 2. with the fall in price there has been a downward movement from A to B along the same demand curve D1D1. if we take B as the original price-demand point. Similarly decrease in demand indicates either that less will be demanded at a given price or the same quantity will be demanded at the lower price. A change in demand.In the figure 2. The consumer moves upwards from point B to A along the same demand curve D1D1. Fig. Increase and Decrease in Demand These two terms are used to indicate change in demand. implies an increase or decrease in demand.

Demand for Consumer’s Goods and Producer’s Goods. In figure 2. Similarly the shifting of demand curve towards its left depicts a decrease in demand. a. In this case a movement from point ‘A’ to ‘B’ indicates that the price remains same at OP. a) Demand for Consumers’ Goods and Producers’ Goods. Demand could be classified in to following types from managerial point of view. increase in demand is Q1Q2 which due to the factor other than price.3 (B) the decrease in demand is depicted by the shift of demand curve from D1D1 to D2D2. Here. Industry Demand and Company Demand f. 21 .3 Types of Demand The demand behaviour of the buyer or consumer is different with different types of goods. 2. Short-run Demand and Company Demand. the demand curve shifted to the right. b. but more quantity (OQ2) is now demanded instead of OQ1. Demand for Perishable Goods and Durable Goods c. Demand by Total Market and by Market Segment. g.The decrease in demand by Q1Q2 quantity is due to the factor other than price. Joint Demand and Composite Demand e.In the case of increase in demand. In the figure 2. Derived Demand and Autonomous Demand d. In this case the movement from point ‘A’ to ‘B’ indicates that the price remains same at OP but quantity demanded decreased by Q1Q2.3 (A) the shift of demand curve from DD to D1D1 shows an increase in demand.

replacement of old products and expansion of the total stock. which are used for the production of other goods. fruits. Sweets. Sales of perishable are made largely to meet current demand. petrol etc. vegetables. whereas in case of a household it is a consumer good. Autonomous demand. Their demand fluctuates with business conditions. The demand for all producers’ good is derived. on the other hand. However the distinction is useful because. machines. ready-made cloth etc. Thus they have two kinds of demand Viz. among other factor. locomotives etc. In case of autonomous demand. Derived Demand and Autonomous Demand The demand for a product is said to be derived demand if demand for such product is tied to the purchase of some parent product. is not derived. raw materials. demand for a product is independent of demand for other goods. these goods satisfies the consumers’ wants directly. add to the stock of existing goods whose services are consumed over a period of time. while durable goods are those. which can be consumed only once. edible oil. Car. Examples for such goods are machines. which depends on current conditions. ice cream. Sales of durables. For example the demand for cement is a derived demand because it is needed not for it’s own sake but for satisfying the demand for buildings. tooth paste. Examples of consumers’ goods can be food items. are perishable goods. tools. refrigerator. demand for consumer goods depends on consumers’ income whereas demand for producer good depends on demand for the products of the industries using this product as an input. Whether a particular commodity is producer good or consumer good depend upon who buys and what for. Consumers’ goods can be defined as those. which can be consumed more than once over a period of time. which are used for final consumption.Producer goods are those. building are durable goods. For example. Today. sugar in the case of a confectioner is a producer good. it is difficult to find the 22 . on the other hand. b) Demand for Perishable Goods and Durable Goods Perishable goods are those. It is important to note that perishable goods are themselves consumed whereas only the services of durable goods are consumed. This distinction is useful because durable products present more complicated problems in demand analysis than the products of durable nature. c. The distinction between consumers’ and producers’ goods is somewhat arbitrary.

bread and butter. For example. However. the demand for petrol is fully tied up with the demand for vehicles using the petrol. the degree of this dependence varies widely from product to product. Each of these segments may differ significantly with respect to delivery price. different use for the product. Sugar industry in India consists of all the companies of the country. competition and seasonal pattern. d) Joint Demand and Composite Demand When two goods are demanded in conjunction with one another at the same time to satisfy a single want. T. Demand for certain products has to be studied not only in its totality but also by breaking it into different segments. they are said to be joint or complimentary demand. different regions. lifting water. Industry demand denotes the demand for the products of a particular industry while company demand means the demand for the products of a particular industry. Electricity is needed for lighting. which produce the sugar. An industry is a group of companies or firms. ironing. sugar and milk and so on. different customers. boiling the water. For example. A commodity is said to be composite demand if it is wanted for several different uses. f) Demand by Total Market and by Market Segment. demand for steel produced by TISCO is a company (TISCO) demand while demand for steel produced by all companies in India is industry demand for steel in India. When these differences 23 . A company is a single firm producing a particular type of goods or services. while the demand for sugar is loosely tied up with demand for drinks. different distribution channels and also its different sub products. Total market demand refers to the total demand for a product where as market segment demand refers to a part of it. profit margin. Shamanur sugars is a company or a firm which produces the sugar. which produce similar goods or services.V. e) Industry Demand and Company Demand At the outset let us understand the concept of industry and company. Viz. Examples are pens and inks.products whose demand is wholly independent of demand for other goods. radio and many other uses. Thus the distinction between derived and autonomous demand is more of a degree than of kind. cooking.

in the short run existing users of electric appliances will make greater use of these appliances but in the long run more and more people might induced to purchase these appliances ultimately leading to still greater demand for electricity. Similarly with the increase in the price of petrol the demand for vehicles is expected to decrease because car and petrol are complementary goods. Therefore. Factors influencing the demand could be classified into two groups. A) Factors Influencing the Individual Demand Factors influencing the individual demand are explained as follows:  Price of the product: Normally. income fluctuations etc. Long-run demand is that which will ultimately exist as result of change in pricing.are considerable. 2.  Income level of the consumer: Purchasing power of an individual consumer depends on his income level. For example. promotion or product improvement after enough time has been allowed to let the market adjust itself to new situation. Consumers with higher income level demand more and more goods compared to the consumers with lower income level.  Price of the related goods: Demand for a particular commodity depends on the price of its related goods such as substitute and complementary goods. g) Short-run Demand and Company Demand. Factors influencing the individual demand and market demand. 24 . a large quantity is demanded at lower price and vis-à-vis. For example if the price of tea increases the demand for coffee is expected increase because tea and coffee are substitutes for many consumers. demand analysis should focus on the individual market segments. income level is an important determinant of demand. Knowledge of these segments’ demand helps a unit in manipulating its total demand. Short-run demand refers to demand with its immediate reaction to price changes. if electricity rates are reduced.4 Determinants of Demand Demand for a commodity depends on various factors.

 Taste. he will buy less at present. A strict vegetarian will have no demand for meat at any price whereas a non-vegetarian who has liking for chicken may demand it even at higher price. In the 25 . In addition to the factors explained above (in section A) following factors influence the market demand. Habit and Preferences of the consumers: People with different taste and habit have different preference for different goods. among other factors. are greatly influenced by the advertisements. cosmetics etc. gutka betel. ice cream. Demand for products like toothpaste. mainly depends on the population size and its growth.  Advertisement: Nowadays advertisement plays crucial role in altering the preferences of the consumers. factors influencing individual demand are also influencing the market demand. A large number of buyers will usually constitute a large demand vis-àvis. coffee.  Expectation: Consumer’s expectations about the future change in the prices of a given commodity influence the demand for such commodity. B) Factors Influencing the Market Demand Market demand is the sum total of various quantities demanded by all the individuals at various prices. Similarly demand for tea.  Distribution of income and Wealth in the country: Market demand for goods and services is more in countries with equal distribution of income and wealth compared to the countries with unequal distribution. he will buy less at the prevailing price. When he expects its price to rise in the future.  Age and sex structure of the population: Age structure of population influences the demand for various goods and services in the market. Therefore.  Growth of population and number of buyers in the market: Market demand for the products depends on the number of buyers. Number of buyers in the market. tobacco is a matter of habits of the consumers. growth of population over a period of time increases the demand for goods and services in the market. Demand for several products like beverages. chocolates and so on are depending on the individual’s taste. Similarly. Therefore. toilet soaps. cigarette. if he expects its price to fall in future.

I.1 26 . Multiple variable models are presented in the following function (2.5 Demand Function A demand function states the functional relationship between the demand for a commodity or services and the factors or variables affecting it. the market demand for toys. This is a single variable model. are more in summer season. Dx = Demand for X Px = Price of x commodity The function 2. Similarly demand for cool drinks. U) Where Dx = Demand for X Px = Price of X I = Income of the consumer Pr =Price of the related goods A =Advertisement or sales promotional activities U =Error term 2. Similarly sex structure also influences the demand for goods and services in the market. school bags.1 demand for commodity X depends on the price of the commodity.2 2. 2. bangals.2).  Climatic conditions: Demand for certain products is determined by climatic conditions. For example demand for goods like saries. is more in the countries with the sex ration favourable to females. fans etc. A. relatively more children. will be relatively more. in rainy season. It does not consider the demand influencing factors other than the price. lipsticks etc. For example. there will be more demand for umbrellas.country with bottom heavy age structure (relatively more children). The demand function for commodity X can be symbolically stated as follows: Dx = f(Px) Where. Dx = f (Px. If sex ratio is favorable to females then the demand for goods and services required for females will be relatively more. chocolates etc. ice creams. Pr. rain coats et.

price of its related goods and advertisement or sales promotion activities. It is a general form of demand function because the independent variables included in the model (RHS) are considered to be influencing the quantity demand of commodity X but it does not reveal in what direction and to what extent they are influencing.6 Elasticity of Demand Demand usually varies with variation in the price. The empirical demand function shows the quantitative relationship between the demand for a particular commodity and its determinants.The demand function 2.1 Meaning of Elasticity of Demand. 2. Elasticity of demand is a useful tool to understand the extent of change in quantity demand due to change in price or other demand influencing factors like income. But it does not states by how much the quantity demand increases as a result of certain fall in the price of the commodity. used as a synonymous of price elasticity of demand. price of related goods and advertisement. Empirical demand function also reveals the direction of relationship between the dependent variables (Quantity demand of a commodity) and independent variables (Demand determinants) through the sign (i. The demand for commodity X might be influenced by the factors other than these factors also.e + or -). The law of demand states that with the fall in the price of commodity.6. the quantity demand increases and vis-à-vis.2 shows that the quantity demand of X influenced by the price of commodity X. income of the consumers. It can be depicted as Percentage change in quantity demand Elasticity of Demand = Percentage change in demand determinant 27 . The term elasticity of demand. The influence of the variables other than those included in the model is represented by error term (U). In the strict sense of the term the concept of elasticity of demand refers to the responsiveness of the quantity demand to the change in demand determinants. very often. 2. This is a loose interpretation of the term.

In the words of Prof. • • • Price elasticity of demand Income elasticity of demand Cross elasticity of demand 2. Obviously. considering its major determinants economists broadly classified the elasticity of demand into following types. Lipsey “Price elasticity of demand may be defined as the ratio of the percentage change in quantity demand to the percentage change in price.3 Price Elasticity of Demand. Using the above formula. It is. price of related good. The coefficient of price elasticity of demand is always negative because price and quantity demand varies inversely with the change in the price of the commodity. income of the consumer. one can obtain various numerical values ranging from zero to infinity. However. 2.2 Types of Elasticity of Demand.” Price elasticity of demand may be written as Percentage change in quantity demand Price Elasticity of Demand = Percentage change in Price In the algebraic form it could be presented as Ep = [ΔQ/Q] / [ΔP/P] Where Ep = Coefficient of Price Elasticity of Demand ΔQ = Change in demand Q = Initial demand ΔP = Change in Price Ep is the coefficient of price elasticity of demand. There are as many types of price elasticity of demand as there are demand determinants. 28 . however. Price elasticity of demand depending on the value of coefficient could classify into different types. depending on the magnitudes and proportionate changes involved in data on demand and prices.6.6.The demand determinants mainly include the price of the commodity. customary to disregard the negative sign. the numerical coefficient of price elasticity of demand can be measured for any given data.

5: Perfectly Inelastic Demand 29 .3. In figure 2.6. Fig 2. consumers The stop Fig 2. B. Thus. In this case. In figure 2.4 DD demand curve is horizontal to OX axis. a slight or infinitely small buying rise it. Perfectly Elastic Demand In case of perfectly elastic demand. perfectly elastic demand has zero coefficient (Ep=0). A.2.4: Perfectly Elastic Demand numerical coefficient of perfectly elastic demand is infinity (Ep=α) The demand curve. there is absolutely no change in demand. in this case. Perfectly Inelastic Demand Perfectly inelastic demand is one for whatever the change in price. in price of a commodity.1 Types of Price Elasticity of Demand. will be a horizontal straight line. the quantity demand shows no response to a change in price. whatever may be the price level the quantity demand remains same at OD.5 DD demand curve is a vertical line. In this case.

7 is relatively steeper. In this case coefficient of elasticity of demand is greater than 1 but it is not infinite. In this case the coefficient of elasticity of demand lies between zero and one. Relatively Inelastic Demand If a decline in price leads to less than proportionate increase in quantity demand. Relatively Elastic Demand If a reduction in price leads to more than proportionate change in quantity demand.6: Relatively Elastic Demand D.6 DD1 demand curve is relatively flatter. the demand is said to be relatively elastic. DD1 demand curve in figure 2.7: Relatively inelastic Demand E. In figure 2. Unitary Elastic Demand 30 . Fig 2. the demand is said to be relatively elastic. For example if 5 per cent decline in price leads to 10 per cent increase in quantity demand.C. For example if a 5 per cent decline in price leads to 3 per cent increase in quantity demand then demand considered to be relatively inelastic. the demand considered to be relatively inelastic. Fig 2.

while necessities are price inelastic. In this case the coefficient of elasticity of demand is one. For example if a 5 per cent increase in price leads to 5 per cent decrease in quantity demand then demand considered to be unitary elastic.2 Factors Influencing Price Elasticity of Demand.8: Unitary Elastic Demand 2. c) The time period: Demand is more elastic in the long run than in the short run.3. d) The number of uses to which a commodity can be put: The more the possible uses of a commodity the greater its price elasticity will be. b) The nature of the need that the commodity satisfies: In general luxury goods are price elastic. The income elasticity is defined as a ratio of percentage or proportionate change in quantity demand to percentage or proportionate change in income. e) The proportion of income spends on the particular commodity: The demand is inelastic if a very small proportion of income is spent on a particular commodity. a) The availability of substitutes: The demand for a commodity is more elastic if there are close substitutes for the commodity.8 is a rectangular hyperbola.Price elasticity of demand is unity when the change in demand is exactly proportionate to the change in price.6. 2. DD demand curve in figure 2.4 Income Elasticity of Demand. The coefficient of income elasticity of demand could be measured by the following formula: Percentage change in quantity demand Income Elasticity of Demand = Percentage change in Income In the algebraic form it could be presented as 31 . Fig 2.6.

A commodity is considered to be a luxury if its income elasticity is greater than unity.6. b) The initial level of income of a country: TV is a luxury in a poor country while it is a necessity in a country with high per capita income.5 Cross Elasticity of Demand. 2. a) Business planning: In India. A commodity is a necessity if its income elasticity is small(less than unity). a) The nature of the need that the commodity covers: The percentage of income spent on food declines as income level increases while the percentage of income spent on the luxuries increases with increase in income level.6.6.1 Factors Influencing Income Elasticity of Demand. The firms can plan out its business accordingly. c) Time period: Time period influence the income elasticity of demand because consumption pattern adjust with a time lag to changes in income. the prospect for long run growth in sales for these goods is very bright.Ey = [ΔQ/Q] / [ΔY/Y] Where Ey ΔQ Q ΔY Y = = = = = Coefficient of Income Elasticity of Demand Change in demand Initial demand Change in income Initial income The coefficient of income elasticity of demand will be positive for the normal goods. Some economists have used income elasticity in order to classify the goods into luxuries and necessities.2 Uses of Income Elasticity of Demand. 2. b) Marketing strategy: Income elasticity of demand is helpful in developing the marketing strategy. per capita income is low and it has been slowly increasing. Since income elasticity of income for luxury goods is more.4. 2. 32 .4.

The coefficient of cross elasticity of demand could be measured by the following formula: Percentage change in quantity demand of X Cross Elasticity of Demand = Percentage change in Price of Y In the algebraic form it could be presented as Ey = [ΔQx/Qx/ [ΔPy/Py] Where Ec = ΔQx = Qx = ΔPy = Py = Coefficient of Cross Elasticity of Demand Change in Quantity Demand of x Initial Quantity demand of x Change in price of Y Initial price of Y The concept of cross elasticity of demand can be useful in determining competitive price strategy and policy in the substitute goods or complementary goods such as coco cola or Pepsi. 2.1 Meaning of Demand forecasting 33 .7. purpose and methods of demand forecasting are discussed. Coefficient of cross elasticity of demand here is taken. Similar is the case with respect to tea or coffee. 2. The related commodity may be substitute or complementary.The cross elasticity of demand refers to the degree of responsiveness of demand for a commodity to a given change in the price of some related commodity. types. tea or coffee. Demand forecasting is an useful tool in anticipating the future demand which enable the business house to take the appropriate business decisions.7 Demand Forecasting In the business production of goods or services is of no use if there is no demand for goods or services produced by the business houses. In this section meaning. as a measure of effect of a change in the price of coco cola on the demand for Pepsi.

Samsung electronic company takes no policy actions to influence its future sales. It is not a speculative exercise into the unknown. But it gives a reasonable accuracy. For example. will cover any period more than one year. covers any period up to one year. While active forecasting estimate the future demand taking into consideration of the likely future action of the firm. However. Based on the level of demand forecasting it could be classified into macro. demand forecasting involves predicting future economic condition and assessing their effect on the operation of the firm and its demand.2 Classification of Demand Forecasting Demand forecasting can be classified into different types based on the different criterion. It can’t be hundred per cent precise. Demand forecasting can be classified into short-run and long run demand forecasting based on the time period. 34 . what would be sales in the year 2010? Such forecasts are passive demand forecasts. a) Short-period and Long period demand forecast: Short-run forecasting. Short-run forecasting useful in taking decision concerning the day to day working of the firm whereas long run forecasting facilitates major strategic decisions. Thus. on the other hand. 2. 10 or even 20 years. Normally it covers the period of 5.Demand forecasting means an estimation of the level of demand that might be realized in future under given circumstances. usually. It is based on mathematical laws of probability.7. Long period. The objective of demand forecasting is to predict the future demand. forecasted level of sales may not be desirable level and so the company may be initiated some sales promotion actions with a view to increase its future sales. b) Passive and active demand forecasting: Passive demand forecasting predicts the future demand in the absence of any action by the firm. Similarly based on the role of the demand forecasting firm demand forecast can be classified into active demand forecast and passive demand forecast. The predicted sales if such planned sales promotion activities are undertaken denote the active forecast. industry and firm level demand forecasting.

which in turn. It is most important from the point of view of managerial decisions. A firm can forecast the demand for its products at its own level. Macro-economic forecasting refers to the forecasting of business conditions over the entire economy.3 Purpose of Demand Forecasting: The purpose of demand forecasting could be classified into purpose of short-term and long-term demand forecasting. Generally. it is undertaken by the trade association and the results are made available to the member firms. Industry and Firm level demand forecasting. A short-term demand forecasting is useful in evolving suitable sales policy in view of the seasonal variation of demand. o It is useful in adopting suitable advertising and promotional programme. o It helps in purchase planning to reduce the cost of operation: Demand forecasting enables the firms to understand the right quantity of resources required to the firm at different points of time. Such forecast is called as macro-economic forecasting. Without sales forecasting a rational financial planning is not possible. It is called firm level demand forecasting. Forecasting the demand for the products of a particular industry is the industry level demand forecasting. Aggregate demand for goods and services in the entire economy can be forecasted.7. 2. reduces the cost of operation.c) Macro. A firm’s need for cash depends on its production level. They are separately explained hereunder: A Purpose of Short-Term Demand Forecasting: o It is useful in appropriate production Scheduling: To avoid the problem of over production and the problem of short supply appropriate production scheduling is essential for which demand forecasting is useful. o It is useful in forecasting short-term financial requirements. o It is useful in determining appropriate price policy: Short-term sales forecasting will help the firm in determination of a suitable price policy to 35 .

The data required for the demand forecasting could be collected through the survey method. In the demand forecasting survey plays vital role. 2.7.1. Demand forecasting may be based on two types of data sources viz primary sources and secondary sources.4.clear off the stocks during the off-season. Survey Method. data collection and analytical methods. and to take advantage in the peak season. Secondary data. 1 Survey Method and 2.4 Methods of Demand Forecasting Demand forecasting mainly involves two important methodological aspects viz. demand forecaster has to collect the data through some sort of survey method. B Purpose of Long-Term Demand Forecasting: o Long-term demand forecasting is useful for planning of a new unit or expansion of an existing unit. Manpower development process has to start well in advance to meet the future manpower requirements.1): i) Experts Opinion Survey Method: In this method the future demand for a particular commodity is estimated based on the opinions of experts in the marketing of that particular commodity. are those which are obtained from someone else records. therefore. has been discussed under two headings viz. o It is useful in planning long term financial requirements o It is useful in planning the manpower requirements. Method of demand forecasting. on the other hand. Since salesmen are in close contact with customers in their 36 . These data are already in existence in the recorded or published form. Demand for any goods or services could be forecasted based on the available information or data on the related parameter. The collected data has to process through some statistical technique. In case of primary data. Econometric Method 2. For the purpose of demand forecasting survey method could be classified into following types (Chart 2.7. Primary data or information is original in nature which is collected for the first time for the purpose of analysis. Manpower development requires long time.

Hence. 37 .respective areas. under this method salesmen are to estimate the expected sales in their respective area. This method is also known as the ‘collective opinion method’ because it takes the advantage of the collective wisdom of the salesmen’s. Through these processes a firm could come out with its final demand forecast. Chart 2.1: Types of Survey Method of Demand Forecasting Survey Method Survey Meyhod Experts’ Opinion Survey Consumers Interview Census Method Sample Survey End Use Method The top executives of the firm are to further examine the total estimated sales in the light of the factors like proposed change in the selling price. It is less time consuming also. The main limitation of this method is that it tends to substitute opinion for analysis of the situation. It is purely subjective and different experts may have significantly different forecasts. corporate heads. dealers etc. advertisement programme. packaging design. change in macro variable like purchasing power of the people etc. These estimates of individual salesmen are to be consolidated in order to obtain the total estimated sales for the future. This method is cheaper and easy to handle. they can forecast consumer behavior in the market in the future.

b) Sample Survey Method: In sample survey method forecaster aimed to ascertain the characteristics of parameter based on the characteristics of statistic. Just it has to collect the information and tabulate them. Suppose ABC firm has about one lakh consumers. For example. consumers are directly asked about their future plan of purchase. But it is an expensive and time-consuming method for the products having large number of consumers. Under this method. Expected aggregate quantity demand of these one-lakh consumers in the forecasting period (say in the year 2010) is parameter of this demand forecasting. the potential future buyers are focal point for the demand forecasting.ii) Consumers Survey Method: Consumers. Report has to be prepared accordingly. In case of sample survey method forecaster need not collect information from all 38 . For example there are ‘n’ number of consumers and their probable demand for commodity X in the forecast period are X 1. ABC company intended to forecast demand for its X commodity. Once this information is collected. This may be done in any of the following ways: a) Complete enumeration method b) Sample survey method c) End use method a) Complete Enumeration Method: Under this method forecaster has to collect information from all consumers of the commodity for which he wishes to forecast the demand. In complete enumeration method forecaster collect information from all the onelakh consumers about their expected quantity demand for forecasting period and forecast the demand based on this information (the details of this method discussed in the earlier section). 1) Complete enumeration method and 2) Sample survey method. demand could be forecasted by simply adding the probable demand of all consumers. X2. X3…Xn then the demand forecast would be X = X1 +X2 + X3 +…Xn In this method the forecasting agency could not introduce any bias of its own. Demand forecaster can draw conclusion about this parameter by two different methods. He asks every consumer the quantity of that commodity he would like to buy in the forecasting period.

one lakh. Production of some other commodity 39 . Forecaster may choose 100 or 500 sample respondents or 1000 or more sample respondents based on the available time. X is the sample statistics because it is estimated for the sample respondents. If sample is not good representative of the population concerned then the results will mislead the producers. However it is not so simple to choose the representative sample. He may adopt simple random sampling method or stratified random sampling method or cluster sampling method or even snowball sampling method according to the nature of the population distribution.e. If sample is properly chosen the sample survey method will yield good results. C) End use Method of Demand Forecasting: This method of demand forecasting is suitable if the producer/firm desire to obtain use-wise or sector wise demand forecasts.N = Aggregate demand for the forecasting period. The value calculated for the sample is known as the sample statistics. For example a commodity may be used for: i. Thus conclusion about the aggregate demand by the one-lakh consumers is estimated by using the data collected from the 500 sample respondents. In this example X .= X 500 Here.the one-lakh consumers. For this example let us assume that the forecaster has selected 500 respondents using the simple random sampling method. budget. expected level of accuracy of the result etc. the demand for a particular commodity is estimated through a survey of its users of different uses. He has to choose some sample respondents out of one-lakh consumers using appropriate sampling method and sample size. ∑X X1+X2+………. Final consumption ii. In this method of demand forecasting.X500 = -----. This method of demand forecasting is less expensive and requires less time when compared to complete enumeration method. In this example N refers to the population size i. After collecting information from the sample respondents he can calculate the expected average demand of these selected respondents for the forecasting period.

iii. Export In this method demand forecaster is to obtain separate demand forecast for these different uses. For example a steel firm wants to forecast demand for steel in the year 2010. It can be obtained as Sd2010 = Sc2010 + Se2010 + asi.(Xi)2010 Where Sd2010 Sc2010 asi. = Total demand for the steel in the year 2010 = Consumption demand for steel in the year 2010 = Steel requirement of ith industry per unit of its output

Se2010 = Export demand for steel in the year 2010 (Xi)2010 = Output of ith industry using steel as an input Consumption demand and export demand could be directly estimated by using the appropriate method. Demand for intermediate use could be forecasted through the survey of its user industries regarding their production plan and input-output coefficients. The principle advantage of this method is that it provides use-wise demand forecast. If the number of end users of a product is limited it will de convenient to use this method. The major weakness of this method is that the individual industry will have to relay on some other method to estimate the final demand of its products for final consumption and export.

2.7.4.2 Econometric Method
The term Econometrics means, literally, Economic measurement. Econometric methods integrate statistics, mathematics and economic theory in order to measure relationship among economic variables. Econometric models provide insights into the relationship between the variables. These insights can be very useful to the managers in evaluating the probable effect of alternative decisions. For example, an econometric study that estimate the impact of advertising on the demand could be used to advertising strategies. The important steps involved in the formulation of econometric models are: 1. Development of a theoretical model, 2 Data collection, 3 Choice of functional form, and 4 Estimation and interpretation of results. Econometric method could be further classified into: 40

i) ii) iii)

Regression method Trend method Leading indicator method

i). Regression Method: Regression is a statistical devise with the help of which it is possible to estimate the unknown value of one variable from the known value of another variable. The variables which is/are used to predict the value of other variable is/are called independent/explanatory variable/variables. The variable we tried to predict is called dependent variable. Estimated regression equation reveals the cause and effect relationship between the dependent and independent variables. It shows the extent to which the value of dependent variable changes with the change in the value/s of independent variable/s. In economic theory it is well-established fact that the quantity demand of a commodity depends on various factors. In simple algebraic form it could be shown as: Dx = f (Px, I, Ps, Pc, A, U) Where Dx = Demand for X Px = Price of X I = Income of the consumer Ps =Price of the substitute goods Pc =Price of the complimentary goods A =Advertisement or sales promotional activities U =Error term/influence of other unexplainable/uncontrollable variables Equation 2.3 reveals that the quantity demand of commodity depends on its own price, income level of the consumers, price of its substitutes, price of complements, expenditure on advertising X commodity, and uncontrollable or unexplainable variables. In this equation U indicates the random error or the influence of other unexplainable or uncontrollable variables. It is a general form of demand function because the independent variables included in the model (RHS) are considered to be influencing the quantity demand of commodity X but it does not reveal in what direction and to what extent they 2.3

41

are influencing. The above general form of function could be presented in any of the following specific form of functions. Dx = a - b1Px + b2I + b3Ps - b4Pc +b5A + U Or Dx = a - Px b1 + I b2+ Ps b3 - Pc b4 +A b5 + U 2.5 2.4

The equation number 2.4 and 2.5 are the linear and power function forms respectively for the variables given in the equation number 2.3. They are nothing but different functional forms of regression equations. In 2.4 and 2.5 equations Dx, Px, I, Ps, Pc, A and U refer to the same meaning as in the equation 2.3. In the equation 2.4 bi’s are the coefficients of the respective variables and ‘a’ is the value of intercept. The estimated coefficient values show the extent to which quantity demand changes with the change in the values of the respective variables by one unit. In this equation some coefficients are having the + sign while others having the – sign. The coefficient of the variables which are having the + sign are influencing the quantity demand positively while the coefficient of the variables which are having the - sign are influencing the quantity demand negatively. In the equation 2.5 all the symbols and letters are used to indicate the same thing as in the equation 2.4. But the only difference is that the estimated coefficient values show the extent to which quantity demand changes with the change in the values of the respective variables by one percent. In the regression equations estimated coefficients are of vital importance. They show the extent of responsiveness of quantity demand to the change in the value of the variables. In order to understand the regression method of demand forecasting let us take the following numerical example. 2004. Table 2.3 provides the data on electric power consumption (in billion K W)(Y) and GNP (in million Rupees)(X) for the period 1995 to

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Table 2.3. Electric Power Consumption and GNP Year Electric consumption (Y) G N P (X) (In Billion K W) (In Million Rs.) 1995 407 944 1996 447 992 1997 479 1077 1998 511 1185 1999 554 1326 2000 555 1434 2001 586 1594 2002 613 1718 2003 652 1918 2004 679 2163 Regression equation could be estimated for this example in order to understand the extent to which the GNP influences the electricity consumption. With the help of the estimated regression equation we could forecast the demand for the electricity for any future date given the value of independent variable for any future date. For this numerical example regression equation of Y on X of the following form could be estimated. Y = a + bX + u 2.6 In order to estimate the values of constants i.e. a and b following normal equations are to be solved. ∑Y = Na + b ∑X 2.7 2 ∑ XY = a ∑X + b ∑X Sum of variables, their products and squares given in table 2.4 are substituted for these normal equations. 5483 = 10 a + 14351b …1 …2 8185955 = 14351a +22103639 b Equation 1 X 1435.1 – Equation 2 7868653.3 = 14351a + 20595120.1b 8185955 = 14351a + 22103639b (-) (-) (-) -317301.7 = -1508518.9b -317301.7 b= -1508518.9 =0.210

43

Substituting the value of b to equation 1 5483 5483 = 10 a = 10 a + 14351 (0.210) + 3013.71

5483 - 3013.71 = 10a 10a = 2469.29 a = 2469.29/10 = 246.929 Y = 246.93 + 0.210X

Table 2.4 Sum Variables, their Products and Squares. Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Sum Y 407 447 479 511 554 555 586 613 652 679 5483 X 944 992 1077 1185 1326 1434 1594 1718 1918 2163 14351 XY 384208.0 443424.0 515883.0 605535.0 734604.0 795870.0 934084.0 1053134.0 1250536.0 1468677.0 8185955.0 X2 891136.0 984064.0 1159929.0 1404225.0 1758276.0 2056356.0 2540836.0 2951524.0 3678724.0 4678569.0 22103639.0

Y = 246.93 + 0.21X is the estimated regression equation. In this equation 246.93 is the value of the intercept. 0.210 is the regression coefficient of X (GNP) variable. It shows that with the increase in the GNP by one million (i.e the unit taken in the independent variable) the consumption or demand for electricity increases by the 0.210 billion K W. For this example the same results could be obtained by the most widely used soft ware Microsoft Excel. The summary output of the Microsoft excel is given in the table 2.5. Intercept and coefficient values are almost as same as we obtained in the above calculation. Besides these values Microsoft excel generate the estimated value of the R2, F value and also t value for each coefficients. The estimated R 2 (0.9452) reveals that the independent variable (GNP) explains the 94.52 per cent variation in the dependent variable. F values are used to draw inference about the overall significance of

44

the estimated regression equation. t values are used to know the significance of the estimated coefficients. Table 2.5 Summary of Output Obtained by Microsoft Excel Regression Statistics Multiple R 0.9768 R Square 0.9542 Adjusted R Square 0.9485 Standard Error 20.0028 Observations 10 ANOVA Df SS Regression Residual Total 1 8 9 66741.20 3200.89 69942.10

MS 66741 .200 400.112

F 166.806

Coefficient s
Intercept Coefficient of GNP (X) Standard Error 246.441 24.213 0.210 0.016 t Stat 10.178 12.915 P-value 7.44E-06 1.22E-06

For same numerical example regression equation of Y on X of the following form could be estimated. Y = a Xb 2.8 Equation number 2.6 is linear regression equation whereas this one is power function. In order to estimate the values of constants i.e. a and b it has to be converted into log linear form of the following type lnY = lna + blnX + u The normal equations to estimate the constants (i.e. a and b) are as follows: ∑lnY = Nlna + b ∑lnX 2.9 ∑ lnXlnY = lna ∑lnX + b ∑(lnX)2 Sum of variables, their products and squares given in table 2.6 are substituted for these normal equations.

45

6793 72.151 + 0.1426 b 455.7205b -0.3759 55.43705 = 10 ln a 10 ln a = 21.23286 – Equation 2 we get 455.1899 7.3286 lnXlnY 41.4864 57.2364 6.4800 6.3733 6.8997 6.5729) + 41.9242 47.1026 6.573 ln X Table 2.1611 42.51085/10 = 2.8501 6. their Products and Squares.151085 Y = 2.43705 = 0.0775 7.4128 b= -0.0088 6.9479 lnX 6.9479 = 10 ln a = 10 ln a + 72.3286 b 455.2933 = 72.3740 7.2682 7.9479 = 10.9969 47.9829 50.51085 lna = 21.9277 46.8631 b Equation 1 X 7.3286ln a + 523.5206 62.0904 44.6950 52.0910 51.0000ln a + 72.3286 (0.62.8099 48.9819 7.8271 54.9479 62.1060 43.7061 (lnX)2 46.4128 = -0.5729 …1 …2 62.9479 – 41.4489 7.3172 6.7205 Substituting the value of b to equation 1 62.573 Or lnY = ln2.8631 b (-) (-) (-) -0.0735 455.8631 46 .4199 45.3190 6.1717 6.6 Sum of Variables.7061 =72. Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Sum Y 407 447 479 511 554 555 586 613 652 679 5483 X 944 992 1077 1185 1326 1434 1594 1718 1918 2163 14351 lnY 6.3286ln a +523.6062 48.1379 45.5590 7.3286ln a + 523.4184 6.7474 50.7061 = 72.1391 58.9709 523.151 * X0.

5465 14.0334 Observations 10 ANOVA df SS MS Regression 1 0.9590 Standard Error 0.9635 Adjusted R Square 0. The summary output of the Microsoft excel is given in the table 2.0011 Total 9 0.In this equation ln2. It shows that with the increase in the GNP by one percent the consumption or demand for electricity increases by the 0. It may be influenced by several variables. Table 2. In case of the multiple regression manual estimation of the coefficients is tedious job. If we use two or more independent variables in the regression models such regression model is termed as multiple regression model. In the regression model we could use two or more than two independent variables.0394 t Stat 7. For this example the same results could be obtained by the most widely used soft wear Microsoft Excel. Nowadays various computer softwares are available to estimate the coefficients in case of multiple regression models.7.0000663 0.1518 0.2451 Coefficients Standard Error 2. 0.0089 0.151 is the value of the intercept.3931 Intercept (lna) Coefficient of GNP (b) P-value 0. The above example has been extended to two independent variable model by incorporating one more independent variable i.2362 Residual 8 0.7:SUMMARY OUTPUT OBTAINED BY MICROSOFT EXCEL Regression Statistics Multiple R 0. For this numerical illustration income elasticity and price elasticity of demand for electricity could be estimated through the following form of equation.9816 R Square 0.8 provides the data on electric power consumption (in billion K W)(Y) and GNP (in million Rupees)(X1) and price of the electricity (in Rs. In practice. 47 .e.2362 0.5394 F 211.573 per cent. price of the electricity.2851 0.5728 0. Per unit) (X2) for the period 1995 to 2004.0000005 In the above example we consider only one independent variable model.573 is the regression coefficient of X (GNP) variable. quantity demand of any commodity will not be influenced by only one variable. Table 2.

The summary of output is given in table 2. Table 2.5834 1.45 3.0002 -0.2451 Coefficients Standard Error t Stat P-value -0.496 0.Y = a X1 b1 X2 b2 2.9849 Adjusted R Square 0.495 48 .1603 0.1512 0./Unit) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 407 447 479 511 554 555 586 613 652 679 944 992 1077 1185 1326 1434 1594 1718 1918 2163 2.78 4. Year Electric G N P (X1) Price of consumption (Y) (In Million Rs.21 3.38 2.09 2.0161 Intercept Coefficient of G N P (X1) Coefficient of Price of Electricity (X2) Y = -0.1408 7.10 In this equation a represent the intercept value.496 X1 1. b1 and b2 shows the regression coefficients of income and price on electric consumption.83 3.0037 0.29 2.9924 R Square 0.8: Consumption. which are same as income and price elasticity of demand for electricity. The value of these constants has been estimated by using the Microsoft excel. GNP and Price of Electric Power.8628 -0.1572 -3.495 0.9806 Standard Error 0.6488 Residual 7 0.03 Table 2.19 2.0230 Observations 10 ANOVA Df SS MS F Regression 2 0.1207 228.) Electricity (X2) (In billion K W) (Rs.0005 Total 9 0.008 X2 –0.008 0.10 2.5748 0.2414 0.9: SUMMARY OUTPUT OBTAINED BY MICROSOFT EXCEL Regression Statistics Multiple R 0.9.

For example if X and Y are close substitutes.In the summery of the regression output the income elasticity of demand for electricity was worked out to be 1. ii.008 per cent increase in the demand for electric power. Yt = Quantity demand of forecasting variable in time t 2. Any social scientist possessing sufficient knowledge of economic theory and econometric methods can use this method for forecasting purpose. increase in the price of X leads to increase in the demand for Y on the day itself. This relationship could be expressed in the following way: Yt = a + bXt-1 Where.495 per cent.11 49 . Demand for agricultural input. Similarly price elasticity of demand for electricity was worked out to be -0. Here agricultural income is a leading indicator because it indicates the fact that there will be more demand for agricultural input in the subsequent year. There are some variables the values of which move up or down ahead of some other variable and such variables are called leading variables or series.008. Leading Indicator Method: The previous section dealt with the relationship between the two or more coincident series. The major limitation of this method is that it requires the use of some other forecasting method to estimate the value of the explanatory variables in the prediction period. which enables us to forecast the demand.495 which means for every one percent increase in the price of electric power there will be fall in the electric power consumption or demand by 0. is lagging variable because its value moves up or down behind the value of agricultural income. Demand has varied by a certain amount or percentage because its determining variables have varied by certain amount or percentage. which means for every one per cent increase in GNP there will be 1. in this example. Agricultural income (harvest) in the year influences the demand for agricultural inputs in the subsequent year. The principle advantage of this method is that the variation in demand is explained through the variation in its casual variables. Coincident variables are those the values of which vary along with some other variables. This is indicated by the regression equation itself. The extent of reliability of the results depends on the extent of the reliability of the estimated future values of explanatory variables.

iii. If the calculated value of ‘b’ is 0. Time series data can be presented either in the tabular form or graphical form. Components of time series 50 . for example. Time series fluctuation can be explained through the different components. In spite of such fluctuation there is a general increasing trend.9. may be next month or year or decade. This method is mainly based on the assumption that the time series will continue to move as in the past. (in thousand) 1998 80 1999 90 2000 92 2001 83 2002 94 2003 99 2004 92 The data shown in the table 2.10 Sales of T V sets Pertains to X Company Year Sales of T. Table2. months or years. Trend Method: Time series analysis or the trend method is one of the most frequently used methods of demand forecasting. The following table.Xt-1 = Value of explanatory variable in time t-1 a & b represent the intercept and coefficient of independent variables respectively The value of intercept and coefficient value could be estimated by using the method discussed in the previous section.75 unit. Time series analysis attempts to forecast future values of time series by examining the past observation of the data only. For this reason this method is also called naïve forecasting. V.10 presented through the graph 2. It is evident from the graph that the sale of the T V sets of the above firm has been fluctuating over the years. The major limitation of this method is that it is not possible to find leading indicator for variable under forecast. But only difference is that the value of explanatory variable pertains to time period t-1. shows the sales of the television sets of X company (in thousand units). Time series data refers to the values of a variable arranged chronologically by days. weeks. The main advantage of this method is that present period value of explanatory variable could be used to predict the demand for (lagging variable) commodity in the next period.75 it implies that every one-unit increase in the value of independent variable in this year leads to increase in the quantity demand by 0.

2. • Cyclical Variation: It refers to recurrent up and down movements of business activities around some sort of statistical trend level or normal business conditions. Changes that have taken place during a period of one year as a result of changes in season i. • Irregular variation: Changes that have taken place as a result of such forces that could not be predicted like floods. festival etc.e. change in the climate. A trend line can be fitted through series either visually i. Fig.9 Sales of T V sets Pertains to X Company 120 100 Sales in thousand 80 60 40 20 0 1 2 3 4 Time in Years 5 6 7 The most important aspect of time series analysis is the projection of trend of the time series. weather condition. freehand method 51 .e. festival etc.• Seasonal Variation: Changes that have taken place during a period of one year as a result of changes in season i. earthquake etc. weather condition.e. change in the climate. they are also called erratic variations • Secular trend: Changes that have occurred as a result of general tendency of data to increase or decrease is known as secular trend.

and the time period respectively. Yt and t are the variables represent the value of the time series to be forecasted for period t. We can measure t by taking either first year or the mid point in the time period as the origin. The straight line could be represented by the following equation Yt = a + bt 2.12 Here. .13 630 = 7a +21b …1 1946 = 21a + 91b …2 Equation 1 ( -3) – Equation 2 -1890 = -21a . The trend equation of the form 2.12 could be estimated to the example given in the table 2. which is taken as the origin.10 by solving the following normal equation. their Products and Squares Year 1998 1999 2000 2001 2002 2003 2004 Sum Yt (000s) 80 90 92 83 94 99 92 630 T (Year – 1998) 0 1 2 3 4 5 6 21 t Yt 0 90 184 249 376 495 552 1946 t2 0 1 4 9 16 25 36 91 2. ∑Yt = Na + b ∑t ∑ tYt = a ∑t + b ∑t2 For fitting the straight-line trend by the least square method we must specify the year.63b 1946 = 21a + 91b 52 . Trend equation could be estimated as follows for the example given in the table 2.13 Substitute the values to the normal equation 2. Table 2. The most popular statistical method that is used in the time series analysis is least square method.11 Sum of Variables. Here the trend equation has been estimated by taking the first year as the origin. a is the intercept and b is the coefficient of the trend equation which shows the absolute amount of growth per period.10.based on the personal judgment or by means of statistical technique.

Therefore. It is a very popular method of demand forecasting not only because of its simplicity but also because it yields good results. most of the time series data follow a particular trend in the long run. It needs only time series data on the variable whose future value is to be forecasted.42 = 7 a 588 = 7 a a = 588/7 = 84 Y = 84 + 2(t) The trend equation reveals that for every one year there will be increase in the sales of T V sets of the X Company by 2000 units. In the long run.7.5 Demand Forecasting for New Products 53 . as it does not require the knowledge of economic theory and the market. Its assumption that the trend equation obtained by the best fit on the past data holds good in the prediction period is not always appropriate. Further. Using this coefficient demand could be forecasted for any future period. this method quite often found appropriate for the long run prediction not for the short run.56 56 b= 28 = =2 28b Substituting the value of b to equation 1 630 = 7 a + 21 (b) 630 = 7 a + 21 (2) 630 = 7 a + 42 630 . Besides it is relatively easy to forecast the demand through this method. it may be good assumption but surely short run fluctuations in most time series do not warrant this method. This method is based on the assumption that the past rate of change of the variable under consideration will continue in the future also which is a major limitation of this method. 2.

Demand forecasting is very difficult for new products because forecaster could not get previous data.7. • Analyze the new product as a substitute for same existing product. Total demand is predicted on the basis of sale in the sample market i. No previous experience on the sales of such product etc. • Survey of consumer’s reaction to a new predict indirectly through the eyes of specialized dealers who are supposed to be aware of consumers’ need and alternative opportunity i. • Offer the new product for sale in a sample market.6 Criteria of a Good Forecasting Method 54 . either by the use of samples or on a full scale i. there are many different demandforecasting methods.e.e.As we have discussed in the previous section. 2. the demand condition of the old product should be taken into account while assessing demand for a new product (evolutionary approach). • Project the demand for new product as an out growth of an existing old product. opinion survey method. It means when a product is evolved from the old one. Demand for new product can be forecasted based on the previous experience of sales trends of already existing substitute products (substitute and growth) • Estimate the demand by making direct enquiry from the ultimate purchasers.e. In this regard Joel Dean has suggested some of possible approaches to forecast demand for new products. How for a new product serves the purpose as substitute to an existing product? If new product is close substitute for existing product. We can make use of any of these methods while forecasting the demand for existing product. Consumers survey method. Sales experience approach.

Clear understanding is necessary for proper interpretation of the results. Techniques. • Economy: Cost must be compared with the importance of the forecast to the operation of the business. Lesser the deviation between these two accurate is the demand forecast vice-versa. cost. etc. It is necessary to check the accuracy of past forecast against present performance and of present forecast against future performance. The method of demand forecasting which poses the above qualities will have greater usefulness. Therefore. Management must be able to understand and have confidence in the techniques used. which take long time to work out. • Flexibility: The techniques used for forecasting must be able to accommodate and absorb frequent changes accruing in the economy. • Availability: The techniques employed should be able to produce meaningful results quickly. However. But it may be too late for management decisions hence it is of useless information. Cost must be less than the importance of the forecast to the firm. it is difficult to choose a best method for a particular situation. level of accuracy. Such criteria are: • Accuracy: The accuracy of the forecast is measured by the degree of deviation between forecasted and actual values of a parameter. • Simplicity: It should be simple to understand. may produce useful information. It is difficult to point out the method. There are certain criteria which could be used to judge the suitable or not of a particular method of Demand Forecasting. 55 . It is not desirable to have a forecast in which cost is greater than the importance of forecast to the firm.Different methods of demand forecasting shows considerable difference with respect to procedure of forecasting. which poses all the qualities. demand forecasting functionaries prefer such method of demand forecasting which poses more number of these qualities.

Distinguish extension and contraction of demand 4.0 10.5 11. Explain how do you forecast the demand for new products 16. Discuss the different methods of demand forecasting 15. Varshney RL.0 Quantity of X Commodity Sold in the Market 20 22 25 28 31 2. Given these data estimate the price elasticity of demand for X commodity. Describe the criteria of a good forecasting method 17 Following table gives the data on the sales level of X commodity at different price level. What is derived demand? Give an example 5. New Delhi-110002 56 . Discuss the different types of Demand 11. What is demand forecasting? 9. 13. Self Review Questions 1. Describe the determinants of demand 12.0 13.2. References/ Suggested Readings 1. Explain the factors influencing price elasticity of demand.8. Sultan Chand & Sons. assuming other things remaining same.9. Define cross elasticity of demand. Define the concept of demand. Distinguish individual demand and market demand 3. Price of X Commodity 10. What is demand function? 6. Explain the law of demand 10. and Maheshwari K. 8.0 12.L: “Managerial Economics”. Critically examine the usefulness of Demand forecasting 14. 2. What is price elasticity of demand? 7.

New Delhi 3. S: “ Managerial Economics: Concepts and Cases”. Tata McGraw-Hill Publishing Company Limited.G.Delhi-110 091 MODULE III: PRODUCTION AND COST ANALYSIS Profit maximization is one of the main objectives of all types of business firms. Gupta. L. Mumbai-400 004 4. In order to maximize the profit.Mithani : “Managerial Economics: Theory and Applications”. Jhingan. Profit = Total Revenue-Total Cost. H. Samuel Paul. New Delhi110 055 6.: “Advanced Economic Theory”.. L. D.Chand & Company Ltd. Mote.M.2. firm tries to increase 57 . McGraw-Hill International Editions. Dominick Salvatore: “Managerial Economics”. Singapore 5 Ahuja. M.: “Advanced Economic Theory”.L. S. Vrinda Publications (P) LTD. V. Himalaya Publishing House.

they try to produce optimum level of output and also to use the least cost combination of inputs. In the last chapter we have discussed about the demand side of the market. labour and capital. X3) Where. Production analysis is done in physical terms while cost analysis is discussed in monetary terms. In other words it can be defined as. which determines the price of the commodities. given the current state of technical knowledge symbolically it can be denoted as follows.1 Production Function: A production function expresses the technological (or engineering) relationship between the output of a commodity and its inputs. Demand and supply are two sides of the market. To know the direction and extent to which output changes due to change in input use level we must 58 .its revenue and lower its costs. X2. Cost analysis deals with various types of costs and their role in decision-making. mathematical relationship that tells the maximum amount of output that can be produced with a given set of inputs. determinants of costs etc. Production and cost analysis (this Chapter) concerned with supply side of the market. Quantity of output of a commodity produced depends on the quantity use of land. Y=f (X1. Production analysis relates physical output to physical inputs in the production and studies the least cost combination of factor inputs. These aspects are studied in production (theories) analysis. 3. factor productivity and returns to scale. But it does not tell the manner and extent to which output changes due to change in input use level. Y = Quantity of output of a commodity. Towards this end. a technical. X1 = Land used in the production of commodity X2 = Labour used in the production of commodity X3 = Capital used in the production of commodity It is the general form of production function.

75% increase in production.25 log C In this production function 0. With this type of production function total output can be estimated for any given value of L and C.75 + 0. It shows every 1 per cent increase in labour leads to 0. It means.01 + 2.estimate the specific form of production function i.1 Statistical Production Function Statistical production function can be estimated by statistical techniques or econometric methods using either cross sectional data or time series data on inputs and output.1.25 In the logarithmic form it can be written as: log Y= log 1. Y=KLα C β Where.25 + 0.01 L0.01 + 0.e. Cob Douglas production function is most widely applicable form of production function. and β = are constants Cob-Douglas are pioneers in estimating a production function of this form for American manufacturing industry using annual time series data for the period 1899 – 1922. In this production function sum of production elasticities is (0. Y = 1.0853 59 . There are many different forms of production function.25=1). 1 per cent simultaneous increase in both inputs leads to 1per cent increase in production. α.8253 log Y = 4. Their estimated statistical production function was. Y = Quantity of output produced L = Quantity of labour employed C = Quantity of capital employed K.25 is production elasticity of capital. specific statistical production function. For example.75 log L + 0. Similarly 0. if unit of labour input used is 1000 units and units of capital input used is 2000 units then. 3. output production will be: log Y = 1.75 log1000 + 0.01 + 0.75 C0.25 log 2000 = 1.75 is production elasticity of labour. It shows that Cob – Douglas production function assumes constant returns to scale.

01 + 2.12665 Y = 13386 Due to increase in input use level by 10 per cent output has increased from 12170 to 13385 i.Y = Antilog 4. Because with the change in the input use level factor productivity goes on changing. in the given state of technical knowledge. Producers have to face various production decision problems.12665 Y = Antilog 4. • Producer has to decide what is the most profitable amount of resource to use in the production of a commodity.83561 log Y = 4.e approximately by 10 per cent increase in output. log Y =1.relationship or laws of production. While estimating the effect of input use on the production level we assume that technology remains constant.e labour input increased from 1000 units to 1100 units and capital input increased form 2000 units 2200 units then the resulting output change is as follows. It shows that Cab Douglas production function assumes constant returns to scale. Production function is useful in such production decision-making process. So production function is technological relationship describing the manner and extent to which a particular product responds to change in quantity of input.25 log 2200 =1. 60 .01 + 0.0853 Y = 12170 If input use level increased by 10% i. Statistical production function clearly revealed the fact that the production function is the technological relationship explaining the maximum amount of output capable of being produced by each and every set of specified inputs. This will be discussed in the factor product.28104 + 0. for example improvement in seeds technology brought about considerable growth in crop yield. But in practice technological changes also influences the production growth.75 log 1100 + 0. at the given level of technology.

Long run is long enough to alter both the variable and the fixed resources for production. Since it deals with input-output relationship in the short run it is also known as factor-product relationship in the short run. • Having certain amount of resources a producer can produce various combinations of output of different commodities. So he has to choose the most profitable product mix to produce in order to maximize his profit. The next section deals with the input-output relation (i. the proportion between variable input and fixed input goes on changing and also the variable factor productivity goes on changing. Production and productivity of an input can be expressed through the following measures. but cannot alter the technology. It is called laws of returns. Short-run is long enough to alter the variable but not the fixed resources for production.• Various combinations of two or more inputs can produce a particular output level of a product. Hence. It is also called the law of variable proportion. In this time period all inputs are variable there will be no fixed inputs. 61 . Production analysis (or theory of production) considers two types relationships viz. Therefore. This we shall discuss in the “least cost combinations of inputs”. If we go on increase the use of variable input while keeping the other factors of production constant.e.2 Law of Returns It is the input-output relationship when one factor of production (input) is variable while others are kept constant. laws of production). In this time period certain inputs are fixed and others are variable. Short-run relationships and long-run relationships. 3. It is called laws of returns to scale. producer has to decide the least cost combination of inputs to produce a specific amount of a given commodity. This theory states that in the beginning variable factor productivity goes on increasing after a certain point of variable input use level its productivity starts diminishing.

• Average Physical Productivity (APP): APP of a factor is the total physical product divided by the quantity of that factor. with all other factors constant. APL increases throughout this stage. In other words it is an addition made to total physical productivity by using an additional unit of input. Up to this point TPL increase at increasing rate beyond this point at decreasing rate. average and marginal physical product of variable input i. • Elasticity of production is more than unity in the I stage production (Ep>1). In figure 3.1 TPL.1). average.e. keeping all other factors constant. Inflection point indicates the change in rate of increase in TPL. say for example labour. indicating the increasing efficiency of variable inputs on the productivity with the increasing use of the variable input. and marginal productivity. 62 . when one input is variable. Second Stage: (L1 to L3) • This stage ranges from the point of maximum average product to the point of maximum TPL or the point of zero MPL. First Stage: (O to L1) • • The first stage extends from the point of origin to point of maximum average product. (APL =MPL when APL maximum) MPL maximum at point ‘M’. while others are constant can be dividend into three stages in such a way that one can locate the rational stage of production in order to ensure the resource use efficiency (Figure 3. labour. APL and MPL shows the Total.• Total Physical Productivity (TPP): TPP of a factor is the total production a producer can obtain by employing different amount of that factor. The input output relation showing total. The corresponding point on TPL is called point of inflection. with all other factors held constant • Marginal Physical Productivity (MPP): MPP of a factor is the extra physical product producer obtains by adding an extra unit of that factor. At this point APL =MPL.

at the end of this stage i.e. In I stage. the average productivity of variable input increasing continuously indicating the increase in 63 . when APP=MPL. Average and Marginal Product of Variable Input (Labour) Third Stage:(Beyond L3) • • • This stage extends from the point of zero MPL to over the entire range of declining TPL.1: Total. when TPL is maximum or MPL is zero EP = 0. between these two points Ep will be less than one but greater than zero. Ep is less than zero.e.• • In this stage TPL increases at decreasing rate In the beginning of this stage i. EP =1. MPL crosses zero point and become negative. Figure 3. I and II stage are considered as irrational stage of production.

Marginal productivity goes on increasing with use of additional unit of input under this law. Increasing Returns: If each additional unit of variable input adds more and more to the total production than their previous unit of input. it is not profitable zone. rY1 /rX1 < rY2 /rX2 < rY3 /rX3< …………rYn /rXn MP of second unit of input is greater than the MP of first unit of input and similarly MP of 3rd unit of input is more than the marginal productivity of 2 nd unit of input and so on. In the above figure we could find increasing returns.its efficiency with the use of additional unit of this input. then it may be called as law of increasing returns. the concept of constant returns is very popular in practice. producer should prefer to produce in the second stage of production where the O<Ep<1. The law of variable proportion is also called laws of returns because in these different stages of production we have seen different returns level for the different level variable input use. No rational would prefer to operate in the stage of negative returns. In between increasing and diminishing returns we could also found constant returns. Therefore. Three important laws of returns are elaborated in the following section. In the III stage of production function. 64 . In other words the law of increasing returns said to exist if MP goes on increasing with the increase in the variable input use level. Hence. Hence if a producer is interested in maximizing his profit it is advisable to use the variable input at least to the point of highest APL. One is declining production and another is unnecessary additional cost of inputs.The optimum level of input use within this stage can be located with the help of factor product price. the total product (TPL) is declining and MPL is negative. It is not reasonable to stop using an additional unit of an input when its efficiency on all units used is increasing. • • • Increasing returns Decreasing returns Constant returns I. diminishing returns and also negative returns. Producers operating in this zone will incur double losses. Though it is not visible in the curve.

disadvantages to size). In other words an increase in the scale of production means that all inputs or factors are increased in the same proportion. He used the concept of returns to scale to capture the idea that firms may alternatively face "economies of scale" (i.3 Laws of Returns to Scale It refers to the behavior of output in response to the change in the scale of production. However. rY1 /rX1 > rY2 /rX2 >rY3 /rX3> …………rYn /rXn Marginal productivity of second unit of input is less than the marginal productivity of first unit of input and similarly marginal productivity of third unit of input is less than the marginal productivity of second unit of input and so on marginal productivity goes in diminishing.ii Decreasing Returns: If each additional unit of variable input adds less and less to the total production than their previous unit of input then it may be called as law of decreasing returns. rY1 /rX1 = rY2 /rX2 =rY3 /rX3 = …………rYn /rXn Marginal productivity of second unit of input is equal to the marginal productivity of first unit of input and similarly marginal productivity of third unit of input is equal to the marginal productivity of second unit of input and so on marginal productivity remains constant for different level of variable input use level. Change in the scale of production means that all inputs or factors changed simultaneously in the same proportion.e.e. 65 . In other words if marginal productivity goes on decreasing with the increase in the variable input use level for that we called as low of decreasing returns. Here MP remains same at all levels of variable input use. 3. Constant Returns: If the amount of output increases by the same magnitude for each additional unit of input then it may be called as law of constant returns. they were not carefully defined till the time of Alfred Marshall. advantages to size) or "diseconomies of scale" (i. The study of change in output as a consequence of change in the scale forms the subject matter of returns to scale. iii. The concept of returns to scale is as old as economics itself.

more than proportionally. • Increasing Returns to Scale: It is a situation where doubling of inputs leads to more than doubling of output.Laws of Returns v/s Laws of Returns to Scale Laws of Returns • Change in output in response to change in the variable inputs • Law of returns is a short run phenomenon • In the short run they could not vary all factors of production. If we increase the quantity of all factors employed by the same (proportional) amount. They could vary only variable factors of production in order to vary their output level. . Even the plant size can be varied in order to vary the output level. does output double. Returns to scale are technical properties of the production function. constant returns to scale and decreasing returns to scale. In other words. x2. y = f (x1. more than double or less than double? These three basic outcomes can be identified respectively as increasing returns to scale. Law of returns to scale is a long-run phenomenon In the long run all factors of production are variable. • • • Laws of Returns to Scale Change in the output in response to change in the scale of production. xn). output will increase. For example if all inputs are increased by 25% and output increases by 30% then we consider this as increasing returns. 66 . or less than proportionally.e. i.. if the increase in all factors without altering the proportion between them leads to a more than proportionate increase in output.. returns to scale is said to be increasing. when we double all inputs. The question of interest is whether the resulting output will increase by the same proportion..

it can make more efficient use of resources by division of labor and specialization of skills. If the increase in all factors without altering the proportion between them leads to a less than proportion increase in output. returns to scale is said to be constant. Although any particular production function can exhibit increasing. But cost of producing that particular level of output by different combinations may not same. if a firm is already producing at a very large scale.e. • Decreasing Returns to Scale: It is situation in which doubling of inputs leads to less than doubling of output. if all inputs are increased by 25% and resulting output increases by 20% then we can say that there is a decreasing return to scale. returns to scale is said to be decreasing returns to scale.4 Least Cost Combination of Inputs: There may be large number of resource combinations which will produces same level of output.• Constant Returns to Scale: It is a situation where doubling of inputs leads to exactly doubling of output. In this topic we shall try to understand how to ascertain least cost 67 . it used to be a common proposition that a single production function would have different returns to scale at different levels of output. if the producer increases all factors in a given proportion and the output increase in the same proportion. For instance. Specifically.e. 3. it often faces increasing returns because by increasing its size. The movement from increasing returns to scale to decreasing returns to scale as output increases is referred to as the ultra-passum law of production. Producer has to incur different level of cost for different combinations. However. it will face decreasing returns because it is already quite unwieldy for the entrepreneur to manage properly. I. constant or diminishing returns to scale throughout. it was natural to assume that when a firm is producing at a very small scale. if all inputs are increased by 25% and resulting output also increases by 25% then we can say that there is a constant return to scale. thus any increase in size will probably make his job even more complicated. i. For instance.

f. any combination of labor and capital along this curve allows the firm to produce 50 units of output per day (for example point B).1:Isoquants: An isoquant curve is a graph of all of the combinations of inputs that result in the production of a given level of output Figure 3. In this diagram labour measured in horizontal axis and capital measured in vertical axis. we will assume that a firm produces output using two types of inputs: labor and capital. Under this assumption. For simplicity. And also we shall try to understand concepts related to least cost combinations. A convenient way of representing this production function is through the use of a graph containing isoquant curves. which is beyond the scope of this course. 3. For now. is a mathematical function that provides the maximum quantity of output that can be produced for each possible combination of inputs used by the firm.4.K) Where: Q = quantity of output produced L = amount of labor input K = amount of capital input The production function. Note that this curve is downward sloping because the firm can replace workers with machines or replace machines with workers and still manage to produce the same level of output. we can define as firm's short-run production function as: Q=f(L. we can think of labor as representing all of the inputs that are variable in the short run and capital as representing all of the inputs that are fixed in the short-run.combination of inputs in producing a particular level of output. The analysis of the multi-factor case requires mathematical tools. In fact. This isoquant suggests that the firm could produce 50 units of output per day using either 20 units of labor and 5 units of capital at point C or 3 units of labor and 15 units of capital at point A.1 shows a hypothetical isoquant. 68 .

More generally. If it uses more of each input it could produce more total output. the firm is using more labor and more capital than it is using at point B. we know that this firm can produce more output at point D than at point B. What happens if we compare points B and D? At point D. r in the use of replaced resource MRSx1x2 = r in the use of added resource = rX2 rX1 69 . in such a way as to maintain the same level of output. Thus. Since the firm produces 50 units of output at points A. we can state that any point that lies above and to the right of an isoquant curve corresponds to a higher level of output. or C. The slope or the nature of isoquant depends on the Marginal Rate of Technical Substitution (MRTS) or simply MRS. the firm can produce 50 units of output using any of the input combinations given by points: A. the level of output will be lower if the firm selects a combination of inputs that lies below and to the left of an isoquant. B. how much the use of one resource can be given up in order to use an additional unit of other input.e. MRS shows the rate at which two resources can be substituted i.1: Isoquant Curve In this diagram.Figure 3. B. and C. the output level corresponding to point B is higher than at any of the points on the isoquant. Using similar logic.

• Perfect Non-Substitutable: If inputs are perfectly non-substitute then such two inputs are to be used in fixed proportion. When input-input relationship is such that isoquant will be convex to the origin. • Limited substitutable: In the production of some commodities there are some inputs. The isoquant that is convex to the origin shows the declining MRSX1X2. this form of isoquants is widely applicable in the least cost combination analysis whereas perfect substitutability and perfect non-substitutability is a very rare event. • Perfect Substitutes: Perfectly substitutable can be replaced each other at a constant rate in order to maintain the same level of output. Inputs are perfectly non-substitute under such input-input relation. In the production of most of the commodities labour and capital are close but not perfect substitutable their substitutability become more and more different as one factor is substituted for another. If two inputs are perfectly substitutable then isoquant in such input-input relation will be a straight line which slopes downward from left to right. On the basis of the extent of the substitutability we can categories input-input relation into three main categories. straight-line isoquant and rectangular isoquants are not much useful in this analysis. in the production of most of the commodities many inputs are substitutable within a certain limits. 70 . If input-input relation is such then isoquant will be of rectangular type. Viz. Here two inputs are substitutable but not perfect substitutable because MRS x1 for X2 goes on diminishing as the producer goes on substituting X1 for X2. Certain products can be produced only if inputs are used in fixed proportion at all levels of production. Practically. Hence. Substitutability become more difficult as X1 input is substituted for X2 input. which are substitutable but not perfect substitutable. Hence. perfect substitutable and limited substitutable (substitutes but not perfect substitutes).MRS of one input for the other in other words slope of an isoquant would depend on the extent of substitutability of the two inputs. perfect non-substitutable.

As labor becomes more plentiful and capital becomes scarcer. For example. The next step towards the determination of optimum/least cost combination of inputs is to add information on cost of those inputs. This seems to be characteristic of most production processes. given the per unit price of capital(r) and labour (w). This law suggests that it takes a large amount of capital to replace a unit of labor when capital use is high but little labor is used. has many workers but few tools. less capital is required to replace an additional unit of labor. however.The law of diminishing MRS states that the MRS declines as the level of labor use rises along an isoquant. the situation on a farm. if w=2 and r=3. Consider. the law of diminishing MRS indicates that it is relatively difficult to replace additional quantities of an input when the level of that input becomes relatively low. If a firm. For example. a very large amount of capital would be required to replace a worker. An equivalent way of stating this law is to state that isoquant curves are convex.4. When a farm is highly mechanized and has only a small number of workers operating the farm equipment. 71 . Thus.2: Iso-Cost Curve: The isoquant curve explains about the physical ways in which inputs can be combined to produce output. This cost information introduced in the form of iso-cost line. Notice that it does not tell us anything about the costs associated with alternative levels of input use. for example. though. the introduction of a small amount of capital (such as a tractor) can replace a relatively large number of workers. the total expenditure (C) on capital and labour is C = rK + wL Rewriting this equation by solving for K as a function of L K = C/r – w/rL This is an equation for straight line where C/r is the vertical intercept and –w/r is the rate at which labour can be exchanged for capital in the market. 3. Let's consider the intuition underlying this law. Iso-cost line indicate all possible combination of two inputs which can be purchased at a given outlay of investment and the market price level of inputs.

in between the two extreme values there will be large number of combination of these two inputs. The Iso-cost line for the given w=2. r=3 and C(outlay) =40 is. 3.2 shows the iso-cost cost lines for the outlay of rupees 30.3: Least Cost Combination of Inputs. 40 and 50 respectively. It is because the input price ratios or the input prices remain constant. Figure 3.5 unit of labour or 1 unit of labour can be traded for 2/3 unit of capital.33 units of capital can be purchased.1 unit of capital can be traded for 1. determination of optimum/least cost combination of these inputs requires that technical information from the production function (i.33 – 2/3L If all the 40 rupees (outlay) is spent on the capital (L=0) 13.4. the isoquant) be combined with the market data on the inputs price (i.e. K 40/3 – 2/3L Or K = 13. 40 and 50 It is clear from the figure that as the outlay of investment on these two inputs goes on increasing the iso-cost line shift outward but they remain parallel to each other.33 units of capital and 20units of labour are the intercept on capital and labour axis respectively. When both capital and labour are variable.2: Iso-Cost Line for Outlay of Rupees 30.e. 13. the 72 . Figure 3. Conversely if all the 40 rupees spent on labour (capital=0) 20 units of it could be purchased.

3. Let us understand this problem with the help of figure 3. At point b 10 units isoquant is tangent to the iso-cost line representing the outlay of rupees 100. Of these. Consider the problem of minimizing the cost for a given level of out put. All other input combinations shown on the 10-unit isoquant would correspond to higher iso-cost curve and would cost more than 100 rupees. clearly b is the best in the sense of being the lowest cost. 73 . Figure 3. b and c. Specifically suppose that the firm’s objective is to produce ten units of output at minimum cost. point a and c are on the iso-cost line representing the expenditure of rupees 150 and b is on the iso-cost line representing the expenditure of rupees 100. The infinite number of capital and labour combinations could produce 10 units of output as shown by the isoquant curve.3: Least Cost Combination of Inputs. Three of these combinations are indicated by a.iso-cost curve). This figure consists of two isoquants. It is important to note that the tangency between isoquant and iso-cost cure at point b indicate that the MRSx1x2 is equal to the factor price ratio which is an important criterion to decide the attainment of least cost.

5.3. yet with less average input costs. time and money could be saved while production levels increased. plant and fixed equipment. The tasks could then be performed better and faster. In a nutshell economies of scale is said to be existing if average cost falls as plant size increases and the diseconomies of scale prevail if the opposite is the case. Adam Smith identified the division of labor and specialization as the two key means to achieve a larger return on production. employees would not only be able to concentrate on a specific task. this means that as a company grows and production units increase. Figure 3. Economies of scale is existing in the range of declining average cost curve and similarly diseconomies of scale is operating in the range of increasing average cost curve. Hence. There are inefficiencies within the firm or industry resulting in rising average costs as the company or production units grow beyond a certain limit. economic growth may be achieved when economies of scale are realized. diseconomies of scale also exist. economies of scale are said to be achieved. improve the skills necessary to perform their jobs. a company will have a better chance to decrease its costs. The concepts of economies and diseconomies of scale are related to economic advantages or disadvantages associated with the scale or size of the plant.4 depicts the economies and diseconomies of scale.e. Alternatively. The understanding of these concepts enables the management to decide about the optimum scale or size of the plant. According to theory. Just like there are economies of scale. through such efficiency. Up to OM level of output average cost goes on declining and it reaches its minimum point at E and there afterwards diseconomies of scale set into the production system hence average cost begins to increase. Scale of production varies only in the long run and hence economies and diseconomies of scale are associated with the long-run decisions.. When more units of a good or a service can be produced on a larger scale. i. 74 . but with time. In this figure economies of scale is prevailing up to OM level of output. Economies and diseconomies of Scale The scale of enterprise or size of plant reflects the amount of investment made in the relatively fixed factor of production. Through these two techniques.

Thus internal economies and diseconomies arise due to the firm’s own expansion. internal economies are more important than external ones. within an industry. Thus. External economies of scale occur outside of a firm.1 Internal and External Economies of Scale Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production. the creation of a better transportation network.4: Economies and Diseconomies of Scale 3. when an industry's scope of operations expands due to. With external economies of scale all firms within the industry will benefit. financial and marking economies and diseconomies. for example. From the managerial point of view. the latter are not subject to such influences 75 . resulting in a subsequent decrease in cost for a company working within that industry. managerial. external economies of scale are said to have been achieved. for a while the former can be affected by managerial decisions of an individual firm changing its size or scale. These include labour.5. technical.Figure 3. internal economies of scale have been achieved. External economies and diseconomies may arise due to the expansion of the industry as a whole.

Large firms can use expensive machinery. average cost begins to fall. which reduces per unit cost. better products. intensively. It is due to: • Labour economies arise in the beginning because expansion of output permits specialization. 76 .5. Sheffield is associated with steel. 3. Technical economies arise because large output permits introduction of new methods of production. • • Specialist local back-up firms can supply parts or services. • etc. television and in national newspapers. For example. As the firm produces more and more goods. • • • • Financial economies made by borrowing money at lower rates of interest Marketing economies made by spreading the high cost of advertising on Commercial economies made when buying supplies in bulk and therefore Research and development economies made when developing new and than smaller firms. Industry expansion may lead to the Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants. An area has a good transport network.3. salesmen. gaining a larger discount. • Technical economies made in the actual production of the good.5.2 Reasons for Internal Economies of Scale These are economies made within a firm as a result of mass production. across a large level of output. construction of a railway line in a certain region resulting in a reduction in transport cost for all the firms • An area has an excellent reputation for producing a particular good.3 External Economies of Scale These are economies made outside the firm as a result of the expansion of the industry as a whole: • A local skilled labour force is available.

• • • • Management becomes out of touch with the shop floor and some Decisions are not taken quickly and there is too much form filling. Unit costs begin to rise because: • Local labour becomes scarce and firms now have to offer higher wages to attract new workers. Thus. eventually average costs begin to rise because: • Labour diseconomies of scale :Once the output has expanded to a reasonable level.5 External Diseconomies of Scale These occur when too many firms have located in one area. resulting in greater efficiency all around. Local roads become congested and so transport costs begin to rise. Thus. which endangers efficiency. there are diseconomies of labour. companies need to balance the effects of different sources of ES and DS so that the average cost of all decisions made is lower. The key to understanding economies and diseconomies of scale is that the sources vary. and lack a sense of responsibility.3. As the firm increases production. it could also give rise to diseconomies of scale if its subsequently widened distribution network is inefficient. 3. machinery becomes over-manned. further expansion leads to problem of over-crowding. • • Land and factories become scarce and rents begin to rise. when making a strategic decision to expand.5. and not just focus on one particular source. Lack of communication in a large firm means that management tasks Poor labour relations may develop in large companies. which renders control and coordination of the labour force difficult. beyond a point. Thus. A company needs to determine the net effect of its decisions affecting its efficiency.4 Internal Diseconomies of Scale These occur when the firm has become too large and inefficient. while a decision to increase its scale of operations may result in decreasing the average cost of outputs.5. 77 . sometimes get done twice.

Its opportunity cost will be nil irrespective of its utility in the existing use. cost of materials purchased.6 Cost Concepts Production analysis. These costs are also commonly known as Absolute costs or Outlay costs.6. actual wages paid.6. Cost analysis. Hence an understanding of the meaning of various concepts is essential for clear business thinking. Opportunity cost of a input or service is measured in terms of revenue which could have been earned by employing that input or service in some other alternative uses. though sometimes difficult.3. to be discussed in this section. for example.1. The kind of cost concept to be used in a particular situation depends upon the business decisions to be made. 3. 3. financial control and auditing purpose while economists’ classification designed to provide decision-making 78 . This analysis equips the future mangers of business houses with various cost concepts suitable for various business decisions. Cost considerations enter in to almost every business decision. The opportunity cost concept applies to all situation where a thing can have alternative use. there are cases where a particular resource or factors of production has no alternative use. An accountant on the other hand would include only the cash payments to the factors of production. etc. for the services rendered by these factors in the production process. Such cash payments are called the explicit costs. interest paid. and it is important. and the cost and output relationships. These costs are the costs that are generally recorded in the books of accounts. relate physical output to physical inputs. Very often. to use the right kind of cost. Actual Cost and Opportunity Cost Actual costs mean the actual expenditure incurred for acquiring or producing a good or service. Opportunity cost can be defined as the revenue forgone by not making the best alternative use. discussed so far. made by the entrepreneur. In economics. deals with various types of costs and their role in decision-making. the cost of production consists of remuneration to all factors of production and the imputed value of the owner's owned resources used for the production of goods and/ or services. Accountants' classifications of costs are usually set up for legal.2 Economic Costs and Accounting Costs Economists' idea of cost of production differs from that of an accountant.

The plant may be fixed today.4 Fixed and Variable Costs Costs are placed in to two broad categories. Therefore. These costs will exist even if no output is produced in the short run. all costs are variable. In the long run all factor inputs are variables. which the firm is bound to pay irrespective of its consumption and the actual bill increases if more than minimum electricity is consumed. For example. and depreciation of building are examples of fixed costs. the fixed factor input is plant and equipment. short-run is defined as a period during which at least one input is in fixed supply. Long run cost analysis useful in investment decision. 79 .6. electricity bills often include a minimum charge. vary. Rent on factory and office buildings. A short run cost is that cost which varies with output when fixed plant and capital equipment remain the same while a long run cost is that which varies with output when all factor inputs. Variable costs. Short run cost is relevant when a firm as to decide whether or not to produce more or less with a given plant. The difference between accounting cost and economics cost could be better understood by the following relationship. They are called semi variable costs. In the long run. but in future company may decide to increase its size to any level desired within the range of possible alternatives. They are neither perfectly variable nor absolutely fixed in relation to changes in output. on the other hand. Fixed costs are defined as those. The short and long run do not refer to any fixed units of calendar time.guideline for management to achieve the economic goals of the firm. an accountant will include only explicit costs in his cost calculation where as economists include not only explicit cost but also implicit cost. there are short run and long run costs. vary directly as output changes.3 Short-Run and Long-Run Costs In economics. which remain the same at a given capacity and do not vary with output. Corresponding to this period classification. Economic Cost = Accounting Cost (explicit cost) + implicit cost 3. which fall between these two extremes. There are some costs. interest payments on bonds. 3.6. including plant and equipment. Examples of variable costs are wages and expenditure on raw materials. fixed and variable cost.

7 Sunk. management may desire to distribute the common costs into various product lines.5 Separable and Common Costs Costs are also classified on the basis of their traceability. On the other hand. Shutdown costs may defined as those costs which would be incurred in the 80 . respectively. and whether to discontinue or modify its production and so on. This is because direct costs can be identified while indirect costs cannot be attributed directly to any unit of operation.g. they can be planned for and planned to be avoided. The entrepreneur might likes to know the total cost of each product line. Future costs are costs that are reasonably expected to be incurred in some future period or periods. Separable costs are those. If the future costs are considered too high the management can either plan to reduce them or find out ways and means to meet them. common costs are those. without being able to do anything for reducing them. 3. for deciding whether or not it is a profitable line of production.6. 3. Just to find out the factors responsible for the excessive costs if any.6. Thus.6. electricity charges may not be separable department wise in a single product firm or even product wise in a multiple product firm. which cannot be traced to any one unit of operation.6 Past Costs and Future Costs Past costs are actual costs incurred in the past and are generally contained in the financial accounts. which can be attributed to a product. It is usually associated with the commitment of funds to specialized equipment or other specialties not readily adaptable to present or future use e. Common costs may create problems in the case of joint products. Then future costs are the only costs that matter for marginal decisions because they are the only cost subject to management control. For example. The separable and common costs are also known as direct and indirect costs. or a process.3. This he may need for pricing purposes. Unlike past costs. brewery plant in times of prohibition. Shutdown And Abandonment Costs A past cost resulting from decisions. The measurement of past cost is essentially a record keeping activity and is essentially passive function insofar as the management is concerned. These costs can merely be observed and evaluated in retrospect. In other words a sunk cost is a cost once incurred cannot be retrieved. a department. which can no more be revised. is called a sunk cost.

If TC = 150. 3. and Q = 30 units.6. Marginal cost concept is essential in deciding whether a firm needs to expand its production or not. If total cost for producing 100 units of output is say rupees 10000 and total cost of producing 101 unit of output is rupees 10110 then Marginal Cost of producing 101th unit of output is (MC101 = TC101 – TC100 = 10110 –10000 = 110) 110. Abandonment arises when there is a complete cessation of activities and creates a problem as to the disposal of assets. a) output level.8 Total Cost. The average cost concept is important for calculating per unit profit of a business concern. It could be obtained by dividing the total cost by total quantity produced (AC = TC/Q).7. Average Cost and Marginal Cost Total cost includes all cash payments made to hired factors of production and all cash charges imputed for the use of the owner’s factors of production in acquiring or producing goods or services. Abandonment costs are the costs of retiring altogether a plant from service. These costs become important when management faced with alternatives of either continuing existing plant suspending its operations or abandoning altogether. Marginal cost is the addition made to total cost by producing an additional unit of output. Average cost is the cost per unit of output. Cost Output Relationship The behavior of cost is of vital importance in the management decision-making process. The general determinants of costs are. In the production decisions average and marginal cost concepts are playing important role. the cost-output relationship is the most important one. then AC = 150/30 =5. Its significance is so great that in economic analysis the cost function usually refers 81 . Of all. 3. the relationships between cost and its individual determinants. b) prices of factors of production. It can be obtained by MCn = TCn – TCn-1. c) productivity of factors of production and d) technology. The cost of production depends on many factors and they vary from one firm to another in the same industry and from one type of industry to another. Examples of such costs are the cost of sheltering the plant and equipment and construction of sheds for storing exposed property.event of suspension of the plant operation and which would be saved if the operations are continued. The relevant costs to be considered will differ from one situation to other depending on the nature of problem faced by the organization.

On the other hand. the short-run cost-output relationship needs to be discussed in terms of. which is sufficiently large to allow the variation in all factors of production including capital equipment. chemicals. 3.to the relationship between cost and rate of output alone. its value will differ. b) variable cost and output. if it has to increase 82 . In the beginning short run cost output relationship is described followed by the long run cost output relationship. one needs to know not only the relationship between total cost and output but also separately between various types of costs and output. casual labour etc. c) total cost and output. and thus assumes that all of the other independent variables are kept constant.1 Total Fixed and Variable Costs in the Short Run There are some inputs or factors. fuel. especially.1. it indicates variations in cost over output for the plant of a given capacity and this relationship will vary with plants of varying capacity. Thus. capital equipment. Thus. the long-run costs are the costs incurred during a period. Thus. 3.7. a firm can readily employ more workers.1 Cost Output Relationship in the Short Run The short-run cost-output relationship refers to a particular scale of operation or to a fixed plant. That is. The cost and output relationship is mainly of two types. The shortrun costs are incurred on the purchases of raw materials. for different plant sizes. Which vary with the changes in the level of output. which can be readily adjusted with the changes in the output level. land and management are held constant. f(x) obviously denotes total variable cost. which are incurred by the firm during a period in which some factors.7. One is short run cost and output relationship and another is long run cost and output relationship. the shortrun function relating cost to output variations is of the following type: TC = f(x) + A Where: TC = total cost X = output and A = total fixed cost The fixed cost is for a given plant size. land and managerial staff to produce a level of output. The Short-run costs are those costs. For decision-making. a) fixed cost and output.

Corresponding to this distinction between variable factors and fixed factors. Such factors are called fixed factors. machinery installed. watchman's wages etc. It requires a comparatively long time to make variations in them. such as factory building. more chemicals without much delay if it has to expand production. it will not use the variable factors of production and will not therefore incur any variable costs. it can secure and use more raw material. the organisation represented by the management and other essential skilled personnel. The short run is a period of time in which output can be increased or decreased by changing only the amount of variable factors such as labour. interest on the borrowed funds. On the other hand. If the firm wants to increase output in the short run. there are factors such as capital equipment. it cannot increase output in the short run by expanding the capacity of its existing plant building a new plant with a larger capacity. Likewise. In the long run. economists distinguish between the short run and the long run. Such factors are called variable factors. minimum administrative expenses such as manager's salary. Variable costs include payments to labour employed. the expense incurred on transportation and the like. Thus fixed cost is the cost incurred towards the fixed factors of production. the prices of the raw material. etc. factory-building etc. It may be noted that the word 'plant' in economics stands for a collection of fixed factors.output. factory building. quantities of the fixed factors such as capital equipment. maintenance costs. Variable costs are also called 83 .. property taxes. it can only do so by using more labour and more raw materials. raw materials. chemicals. In the short run. the long run is defined as the period of time in which the quantities of all factors may be varied. Fixed costs are also known as overhead costs and include charges such as contractual rent. cannot be varied for making changes in output. If a firm shuts down its operation for some time in the short run. fuel and power used. insurance fee. top management personnel that cannot be so readily varied. On the other hand. the output can be increased not only by using more quantities of labour and raw materials but also by expanding the size of the existing plant or by building a new plant with a larger productive capacity.

the total variable cost curve (TVC) rises upward showing thereby that as the output increased.5 Short-Run Total Fixed. variable and total costs curves are portrayed in Figure 3. On the other hand. TC = TFC + TVC The short-run total fixed. Thus variable cost is the cost incurred on the variable factors of production. Since the total fixed cost remains constant whatever the level of output. the greater the output. the total variable cost also increases. In symbol we write TC = f (q) 84 . It will be seen in the figure that the total fixed cost curve (TFC) starts from a point on the y-axis meaning thereby that the total fixed cost will be incurred even if the output is zero. Total cost is the sum of these two costs. Variable and Total Costs. the greater will be the total cost.5 where output is measured on X-axis and cost on Y-axis.prime costs or direct costs. It should be noted that total cost (TC) is function of the total output (q). the total fixed cost curve (TFC) is parallel to the X-axis. The total variable cost curve TVC starts from the origin which shows that when output is zero the variable costs are also nil. Figure 3.

In other words. L. TC must also rise. the marginal product of that variable factor first increased. that is. then remains constant and finally starts diminishing.w TC = K + L. TVC is equal to the amount used of the variable factor say. From the above equation it is clear that with the increase in L. multiplied by the given price of the variable. 85 . then at a constant rate and eventually at an increasing rate. L. and then it starts rising at an increasing rate. Because. TVC = L. total variable cost increases at a decreasing rate. According to this law as more and more units of a variable factor of production are used along with a fixed factor of production. It will be seen from the table that the vertical distance between the TVC and TC curves is constant throughout.w. the increase in output may become increasingly costly because the variable factor inputs may not be easily available or they may have to be paid higher price than before. its nature is such that in the beginning as output increases.. As per economic theory. Now. because only by increase in the amount of variable factor.we can prove this as follows: TC = TFC + TVC Suppose TFC is equal to K. the requirement of labour does not change linearly with quantity produced. Yet another reason for a non-linear total variable cost and output relationship is the operation of the law of diminishing returns. say. and there is the operation of the law of diminishing returns. by increase in L. Thus. total cost (TC) is function of total output (q) and varies directly with it. which remains and changed as output is increased in the short run. This is because the vertical distance between the TVC and TC curve represents the amount of total fixed cost. that the output can be increased.w. This is so because the need for variable factor inputs for increased output behaves in a similar fashion. as output rises. that is. W. the increase in total variable cost goes on increasing at the diminishing rate up to a certain level of output. Once the output has reached a reasonable level. then remains constant for some range of output.w. TVC must rise with the increase in output. which is a constant amount whatever the level of output.

7 17. Important average cost concepts used in the decision-making are Average Fixed Cost. the column 6 gives the average fixed cost. AFC = TFC /Q Where Q represents number of units of output produced.3. which is being. as shown in the figure 3. the total fixed cost spreads over more and more units and therefore average fixed cost become less and less. very widely used in practice. In the table 3. Therefore.1. slops downward throughout its length. use the costs in the form of cost per unit. or average costs rather than totals.5 17 500 73 3000 7300 10300 6 14.5 22.7. Average Variable Cost and Average Total Coast. Therefore. Table 3. the average fixed cost can be obtained by the dividing the total fixed cost by the level of output.1.3000) average fixed cost steadily falls as output increases. Besides marginal cost is another important concept. AVERAGE FIXED COST (AFC): Average fixed cost is the total fixed costs divided by the number of units of output produced. Since total fixed cost is a constant quantity (Rs.6 33 86 .7 8 400 40 3000 4000 7000 7.5 5 300 23 3000 2300 5300 10 7.5 10 17. As output increases. Thus. very often.1: Different Cost Concepts Quantity Number of Total Total Total Cost A F C AVC ATC MC of Workers Fixed Variable Output (L) Cost Cost (1) (2) (3) (4) (5) (6)= 3/1 (7) = 4/1 (8) = 5/1 (9) = ∆5/∆1 100 10 3000 1000 4000 30 10 40 40 200 15 3000 1500 4500 15 7. In practice businessmen and economists. When output becomes very large average fixed cost approaches zero.6 20. average fixed cost curve. The AFC curve gets very nearer to but never touches either axis.6.2 Average and Marginal Cost Curves in the Short Run The above section describes the total cost concepts and output relationship.

The average variable cost curve is shown in figure 3. Thus.6: Relationship between Output and Different Cost Curves AVERAGE VARIABLE COST (AVC): Average variable cost is the total variable cost divided by the number of units output produced. reaches minimum and rises.6 by the curve AVC which first falls. The average variable cost will generally fall as the output increases from zero to the normal capacity of output. Then afterwards average variable cost will rise steeply because of the operation of diminishing returns. It will be seen that average variable cost falls until 200 units of output and there after it increases. Therefore. average variable cost is variable cost per unit of output.Figure 3. AVC = TVC /Q Where Q represents the total output produced. This can be proved as follows: ATC = TC / Q Since TC = TVC + TFC 87 . ATC = TC /Q Since the total cost is the sum of total variable cost and total fixed cost. the average total cost is also the sum of average variable cost and average fixed cost. AVERAGE TOTAL COST (ATC): The average total cost or what is called simply Average cost is the total cost divided by the number of units of output produced.

almost of a 'U' shaped. MARGINAL COST (MC): The concept of marginal cost occupies an important place in the economic theory. This impels that short run ATC will have a U . which more than offsets the fall in AFC. The behavior of the average total cost curve will depend upon the behavior of the average variable cost curve and average fixed cost curve. the ATC curve therefore falls sharply in the beginning.Therefore. there is a sharp rise in AVC. ATC = (TVC +TFC)/Q or AVC + AFC It will be seen from table 3.. Therefore.1 that as output increases. until 400 units of output produced average total cost falls and thereafter it is rising. But as output increases further.6. therefore. which is shown in figure 3. it can also be written as: MC= ∆TC/∆Q Where ∆TC represents a change in total cost and ∆Q represents change in the output. This is because during this stage the falls in AFC curve weighs more than the rise in the AVC curve. Where n is any given number. the ATC curve rises after a point. The ATC is. Marginal cost is an addition made to the total cost by producing an additional unit of output.shape. but AFC curve is falling steeply.e.1 when output increase form 100 units to 200 units the total cost increased form rupees 4000 to 4500. In other words. marginal cost is the addition to the total cost of producing 'n' units instead of n-1 units (i. Therefore. MC = 500/100 = 5 88 . Therefore. When AVC curve begins rising. in the initial stages. In the beginning.TCn-1 This formula is suitable when the output data available in individual units. the ATC continues to fall. Here change in quantity of output (∆Q) is 100 units and similarly change in total cost is rupees 500. In the table 3. that is. reaches its minimum value and then rises. ATC like the AVC curve first falls. Since marginal cost is a change in total cost as a result of a unit change in output. MCn = TCn . When the output data is in the aggregate form MC could be obtained form the alternative formula. both AVC and AFC curves fall. It can be written as. one less).

When marginal cost is below the average cost average cost is falling. Similarly when MC = AC latter is at its minimum point. We can find some interesting relationship between average cost and marginal cost. It is important to note that all production is done in the short run during which the plant size is given. SAC1. consider the three short run average cost curve as shown in the figure 3. in 89 . It is worth to recall the fact from laws of returns. the above-mentioned long-run cost function contains a family of short-run cost functions. The long run total cost function will be of the following form: TC = f (x. average productivity is at its maximum point. long run consists of all possible short run situations among which the firm has to choose to produce a target level of output. In the long run. Productivity and cost moves in the opposite direction. TC also changes. refers to time period during which full adjustment could be made through varying all inputs including capital equipment and factory building. the long run average cost curve depicts the least possible average cost for producing various levels of output. the firm can make a large plant if it has to increase its output level and a small plant if it has to reduce its output. Marginal Cost curve also falls in the beginning and then increase continuously. one for each value of k. SAC2 and SAC3 shows the different plant size and the producer.2 Cost Output Relationship in the Long Run The long run. Thus. When average productivity is equal to marginal productivity.Like other average cost curve. In order to understand how the long run average cost is derived. Marginal productivity curve intersect the average productivity curve from the above. there is no fixed factor of production and hence there is no fixed cost. k) Where k stands for the plant size and x stand for the output level. As k changes.7. When MC is above the AC average cost is increasing. therefore. 3. Therefore.7 The short run average cost curves are also called plant curves because in the short run plant size is fixed and each of the short run average cost curve correspond to a particular plant. In the short run the firm tied with a given plant whereas in the long run the firm moves form one plant size to another. Therefore we can find such a relationship between AC and MC. as already explained above. Thus.

If the firm further wants to produce the output beyond the OD level then the firm needs to further expand its size. Plant size SAC1 is suitable size to produce the OB level of output to OD level of output. production on SAC1 curve entitles lower cost than on the SAC2. In the long run the firm has a choice in the employment of a plant. To produce exactly OB level of output average cost is same on both the plant size under such circumstances it is rational to choose SAC2 because it contains reserved capacity at that level. It is clear form the figure that up to OB amount of output.7: Short Run Average Cost Curve for Different Plant Size.the long run. the firm will operate on the SAC1 though it could also produce with SAC2 because up to OB amount of output. 90 . and it will employ that plant which yield minimum possible unit cost for producing a given output. if the level of output OA is produced with SAC1 it will cost AL per unit and if it is produced with SAC2 it will cost AH per unit. If the firm wants to produce an output. Similarly all other output levels up to OB can be produced more economically with smaller plant SAC1 than with larger plant SAC2. Figure 3. could choose any of these plant size according to his requirement. Obviously AL is smaller than AH. The long run average cost curve depicts the least possible average cost for producing various levels of out put when all the inputs including the plant size is variable. then it will be economical to produce on SAC2. Thus. which is equal to or larger than OB. For instance.

will be of the type shown in Figure 3. Therefore. Figure 3. there my be infinite number of shot run average cost curves.If the output is small. the total cost is less for a small plant size than for a large plant size and quite the reverse holds good for large outputs.8: Long Run Average Cost Curve In any case. Since an infinite number of short run average cost curves are assumed. In fact. This is so because if a large plant is installed it will remain under-utilized when output is small while a small plant will be inadequate or insufficient for large outputs. Thus. the family of short-run total cost curves. one for each plant size.8. it will pick a point on the long run average cost curve corresponding to that output and it will then build a relevant plant 91 . The Long Run Average Cost (LAC) curve is to draw in such a way as to tangent to each of the short run average cost curves. every point on the long run average cost curve will be tangency point with some short run average cost curve. the long run average cost curve is also called envelope because it supports a family of short run average cost curves. long run average cost curve is nothing else but the louses of all these tangency points. If a firm desires to produce a particular output in the long run.

as organizations desire to have some reserved capacity. In the modern days plants. Several reasons have been put forward to explain the why long run cost curve is L shaped rather than U shaped. 8 Define production function What is Isoquant? Define iso-cost line with suitable example Distinguish between laws of returns and laws of returns to scale Distinguish between fixed cost and variable cost Mention determinants of cost. managerial decision making process.8. Explain the application of Critically examine the importance of isoquant and iso-cost curve in the production function analysis in solving these problems. generally. will have a capacity larger than the expected average level of sales. 2. due to the serious policy implications of the economies of large-scale production.and operate on the corresponding shot run average cost curve. 3. 5. the short run average variable cost in the modern version has a saucer type shape. That is it is broadly U shaped but has a flat stretch over a range of output.7. 92 . Thus. 3. In this example plant size indicated by SAC4 is an optimum plant size because the minimum point of this cure tangent the minimum point of the LAC curve. 6. Self Review Questions 1. The shape of the long run cost curve has attracted greater attention in economic literature. 7. 4. which reflects the fact that firms build plant with some flexibility in their productive capacity. According to the modern theory long run average cost curve is L shaped. It has been argued that managerial diseconomies can be avoided by the improved method of modern management sciences. 3. As early as 1939 George Stigler suggested that the short run average variable cost has a flat stretch over a range of output.3 Modern Views on Cost Output Relationship The U shaped cost curves of the traditional theory have been questioned by various writers both on theoretical a priori and on empirical grounds. Mention the production decision problems.

. Ahuja. Jhingan.9. 10. New Delhi 3. Craig Petersen. New Delhi110 055 7. Maxwell Macmillan International editions.. 2. MC .L: “Managerial Economics”. Gupta. Average Cost (AC) and Marginal Cost (MC) and complete the following table Units of FC Output 0 10 20 30 40 50 60 70 TVC 2000 2000 0 1400 3860 2000 2000 2200 2800 5000 5800 7000 105 60 100 TC AFC 2000 . Samuel Paul. S. Total Variable Cost (TVC).: “Advanced Economic Theory”.L. AC .... H.: “Advanced Economic Theory”. Total Cost (TC). M. A. McGraw-Hill International Editions. S: “ Managerial Economics: Concepts and Cases”.9. Varshney RL. Sultan Chand & Sons.M. Mumbai-400 004 4. Dominick Salvatore: “Managerial Economics”.Chand & Company Ltd. Himalaya Publishing House. New York 5.. Mote. Singapore 6. Average Fixed Cost (AFC). 2800 100 46 AVC . Tata McGraw-Hill Publishing Company Limited.Mithani : “Managerial Economics: Theory and Applications”.. Hong Kong. V. L. Koutsoyiannis. Explain the managerial uses of cost output relationship. 80 3. and Cris Lewis. Vrinda Publications (P) LTD.. L. Explain Fixed Cost (FC).W: “ Managerial Economics”. New Delhi-110002 93 .Delhi-110 091 8. H..G.: “Modern Micro Economics”. D. References/ Suggested Readings 1. ELBS With Macmillan. and Maheshwari K.

Of all the criteria used for the classification of the market competition is most important from the management decision point of view. R. What is needed for a market is a group of potential sellers and buyers are in close contact with each other through any means so that transaction processes take place. thus.MODULE-IV: MARKET STRUCTURE AND PRICE DETERMINATION Determination of price is an important managerial function in all kinds of business organizations. the market for management faculty has no specific location. A market can. Market classification based on the competition is explained under the heading market structure. This chapter brings these issues together in order to describe the determination of the price of goods and services. Preceding chapters described the demand and supply of goods and services. 4. market may be physically identifiable e. In other words market can be described as an arrangement whereby buyers and sellers come in close contact with each other directly or indirectly to sell and buy goods or service at mutually agreeable prices. time element and competition. The last section of this chapter describes the pricing method in practice. K. be a specified place or location where buyers and sellers actually come face to face for the purpose of transacting their business. It deals with the meaning and types of market and theoretical market models of price and output determination. Therefore. But concept of market does not refer only to a fixed location. Market in Bangalore. Market in Bangalore is located in particular location. rather it refers to the entire formal and informal network on teaching opportunity throughout the nation. 94 . R.2 Types of Markets Markets may be classified on the basis of geographical area. Only a passing reference is given about the market classification based on the other two criteria. On the other hand. 4.1 Meaning of Market A Market is an institutional arrangement under which buyers and sellers can exchange some quantity of goods and services at mutually agreeable prices. but need not.g. Market. For example K. refers to the conditions and commercial relationships facilitating the transaction between buyers and sellers.

In the long run firms could adjust their supply in the changing demand condition. and oligopoly (table 4. Similarly the short period is a time period during which it is possible for a firm to expand output by using more of variable inputs but not the fixed factors of production. In this time period firms could make some adjustment in the supply according to the changing demand condition. 4. vegetable. Regional markets.1).2. Kannada films have wide market in Karnataka because it is the language of this region. Three market structure models with varying degrees of market control on the supply side of the market are: monopoly. The long period refers to a time period during which firm could adjust its scale of production in order to meet the changing demand condition. It is confined to a particular village. short period and long period. Perfect competition represents the benchmark market structure that contains a large number of participants on both sides of the market. national market and world market. Same is the case with the world market. fruits. Three lesser-known market structures with 95 . The market period is regarded as a very short period during which it physically impossible to change the stock of the commodity. monopolistic competition.1 Market Structures: The nature of competition in market depends on the number of participants in the market and nature of commodity. Perishable goods like milk. In this period it is not possible to make any adjustment in the supply to the changing demand condition. Goods or services. and no market control by any firm. town or city only. etc. which together determine the extent of market control of each participant. When goods are demanded and sold on a nation wide scale. Local market has a narrow geographical coverage. • Based on the time element market could be classified into market period.• Based on the geographical area markets could be classified into Local markets. are generally traded in local markets. such goods said to acquire the national market. will be traded in regional markets. which have the regional importance.

soap etc.2.1. and perfect knowledge of prices and technology. Perfect competition is an idealized market structure that is not observed in its purest form in the real 96 . Supply-Side Market Structures The structure of a Market primarily depends on the number of firms operating in the market. Varying degrees of market control among sellers generate three alternative market structures viz. Table 4. Aluminum Automobiles A few utilities public DifferentiatedFew Monopoly One 4.varying degrees of market control on the demand side of the market are: monopsony. • Perfect Competition: Perfect competition is an ideal market structure characterized by a large number of participants on both sides of the market. Monopolistic competition and Oligopoly. and monopsonistic competition. Perfect Competition is the theoretical benchmark of efficiency achieved because large number of participants in the market gives neither buyers nor sellers market control. oligopsony. The product sold by each firm in the market is identical to that sold by every other firm. In general. Monopoly.2. Buyers and sellers have complete freedom of entry into and exit out of the industry. more competition means less market control. Other market structures have different amounts of market control due to different numbers of competitors. Steel. Kind of Competition Number of firms Nature of Products Degree of control over price Part of economy where prevalent Perfect Competition Perfect Competition Large number Homogeneous None A few agricultural products Imperfect competition Monopolistic Competition Oligopoly Pure Large number Few Differentiated but close substitutes Homogeneous Differentiated Unique Some Some Some Considerable Tooth paste. Classification of Markets (Based on Competition).

A key feature of monopolistic competition is product differentiation. perfect competition efficiently allocates resources. based on the opportunity cost of production. is equal to the supply that sellers are willing to accept. It does this by exchanging the quantity of goods that equate price and marginal cost. based on the satisfaction received. The demand for monopoly output is the market demand. In particular. However. the demand price buyers are willing to pay. It characterized by a small number of relatively large competitors. Further. Monopoly is the worst-case scenario of inefficiency on the selling side of the market and thus is often subject to government regulation. Oligopoly tends to have serious inefficiency problems. While unrealistic. It could 97 . While market control always means inefficiency. Monopoly contains a single seller of a unique product with no close substitutes. each with substantial market control. which helps satisfy diverse consumer wants and needs. The output of each producer is a close but not perfect substitute to that of every other firm. Individual participants must exchange goods at the market price and none can influence the market in any way. monopolistic competition is not a serious offender. • Oligopoly: Oligopoly is closer to monopoly. both buyers and sellers are price takers. but also provides the benefits of innovation and large-scale production. which can lead to intense competition and the motivation to cooperate through mergers and collusion. • Monopolistic Competition: Monopolistic competition residing closer to perfect competition. With a large number of participants. some of the agricultural products possess main feature of perfect competition market.world. It characterized by a large number of relatively small competitors. each with a modest degree of market control on the supply side. For this reason. its primary function is to provide a benchmark that can be used to analyze real world market structures. Oligopoly sellers exhibit interdependent decision-making. characterized by a single competitor and complete control of the supply side of the market. • Monopoly: Monopoly.

two other market structures that tend to appear in the analysis of product and factor markets are duopoly and bilateral monopoly.3. • Bilateral Monopoly: This is a market containing one seller and one buyer. Demand-Side Market Structures While the focus of market structures usually falls on the supply-side of markets. Besides these four markets. 4. Pure Oligopoly and Differentiated Oligopoly. Monopsony. it is perhaps most important as a tool used to analyze oligopoly. Monopsony contains a single buyer in the market and represents the demand-side counterpart to monopoly on the supply side.2. based on the nature of commodity viz. The supply facing a monopsony is the market supply. This market structure provides a great deal of insight into unionized labor markets. In effect.be classified into two kinds. Monopsonistic competition represents the demand-side counterpart to monopolistic competition on the supply side. While the duopoly market structure can and does exist in the real world. • Monopsony: Monopsony characterized by a single competitor and complete control of the demand side of the market. it is the merger of monopoly from the selling side with monopsony from the buying side. varying degrees of market control on the demand side generate three additional market structures viz. where the employer is the single monopsony buyer and the labor union represents the monopoly seller. each with a modest degree of market control on the demand side. Monopsony is the worst-case scenario of inefficiency on the buying side of the market. While market control 98 . • Monopsonistic Competition: Monopsonistic competition characterized by a large number of relatively small competitors. • Duopoly: This is a special type of oligopoly that contains two firms. A key feature of monopsonistic competition is product differentiation as each buyer seeks to purchase a slightly different product. Monopsonistic Competition and Oligopsony.

4. In the strict sense of the term it is not observed in the real world. • Oligopsony: Oligopsony characterized by a small number of relatively large competitors. 4. Perfect Competition This is one of four basic market structures. It is also clear from the above demand side market structures that. Oligopsony tends to have serious inefficiency problems. perfect competition efficiently allocates resources. without any restriction of entry into and exit out of the industry. each of which is relatively small compared to the overall size of the market. each with substantial market control.3.3. exhibit interdependent decisionmaking. Oligopsony represents the demand-side counterpart to Oligopoly on the supply side. It ensures that no single firm can influence market price or quantity. (2) identical products. In particular. Monopsonistically competitive buyers are often on the other side of a market containing monopolistically competitive sellers. it does provide an excellent benchmark that can be used to analyze real world market structures. It characterized by a large number of small firms. as the number of participants on the demand side of the market increases market control decreases.1 Characteristics of Perfect Competition The four characteristics of perfect competition are: (1) large number of small firms. • Large Number of Small Firms: A perfectly competitive industry contains a large number of small firms. which can lead to intense competition and the motivation to cooperate. and perfect knowledge of prices.always means inefficiency. and (4) perfect knowledge. (3) perfect resource mobility. producing and selling homogeneous products. monopsonistic competition is not a serious offender. like their oligopoly counterparts. It is an idealized market. While unrealistic. Some important characteristic features of this market structure are discussed hereunder. If one firm decides to double its output or stop producing 99 . Oligopsony buyers.

1 Pure Versus Perfect Competition Competition is classified into Pure and Perfect competition. No firm can produce its good faster. Likewise." The essential feature of this characteristic is not so much that the goods themselves are exactly. buyers cannot tell which firm produces a given product. perfectly the same. All perfectly competitive firms have access to the same production techniques. In particular. The price does not change and there will be no change in the quantity exchanged in the market. i) There are large number of buyers and sellers ii) Goods produced and sold are homogeneous iii) There is Free Entry or Exit for any producer or seller iv) Perfect knowledge on the part of the buyers and sellers about market conditions 100 . buyers are completely aware of sellers' prices. what is often termed "homogeneous goods. • Identical Products: Each firm in a perfectly competitive market sells an identical product. such that one firm cannot sell its good at a higher price than other firms. a perfectly competitive firm is not prevented from leaving an industry. better.3.entirely. Government rules and regulations or other barriers do not restrict the firms.1. the market is unaffected. • Freedom of entry and exit: Perfectly competitive firms are free to enter and exit an industry. the market is considered to be pure competition if it possesses the six conditions listed below. Contrary to it. • Perfect Knowledge: In perfect competition. So. There are no brand names or distinguishing features that differentiate products. or cheaper because of special knowledge of information. they do not inadvertently charge less than the going market price. Each seller also has complete information about the prices charged by other sellers. 4. The market is said to be pure competition if it possess only first three conditions. but that buyers are unable to find any difference.

It can sell all of the output it wants at the going market price. At OP market price. The conditions of perfect competitive market ensures that a single price must prevail under perfect competition and the demand curve (or average revenue curve) faced by an individual firm is perfectly elastic at the ruling price in the market. If a firm is able to sell any quantity of output at the market price. At this market price level an individual firm could sell any amount of the commodity. hence. As a price taker. In the figure (4. Since demand curve is horizontal to OX axis an 101 . this price is also equal to the marginal revenue and average revenue generated by the firm. the demand curve (or average revenue curve) for an individual firm is horizontal to OX axis. It signifies that the firm does not exercise any control over the price of the product. That is a perfectly competitive firm faces a horizontal demand curve. Demand and Revenue Curve of a Perfect Competitive Firm.1. Therefore. then buyers can simply buy output from any of the large number of perfect substitutes produced by other firms. A firm is able to do this because it is a relatively small part of the market and its output is identical to that of every other firm. It could be explained with the help of the figure 4. Market price (OP) determined by the Market demand (DD) and market supply curve (SS) at point E. it has no reason to charge less. Because the price faced by a perfectly competitive firm is unrelated to the quantity of output produced and sold. revenue per unit sold. the firm has no ability to charge a higher price and no reason to charge a lower one.v) Perfect mobility of the factors of production. is also equal to market price. If it tries to charge more than the going market price. Each firm in a perfectly competitive market is a price taker and can sell all of the output that it wants at the going market price. P AR=MR is the demand curve for an individual firm (in the panel B of the figure).3. and vi) Proximity to the market/ no extra transport cost 4. the firm could sell any amount of commodity at the existing market price its demand curve (AR curve) is horizontal to OX axis. In the perfect competitive market. Since. then the average revenue. When AR curve is horizontal to OX axis naturally AR is equal to MR. market price determined by the market demand and market supply curves.2.1 A).

Moreover. As already explained in the preceding chapters. Demand Curve of a Perfect Competitive Firm. the short run means a period of time within which the firms can alter their level of output only by varying the level variable input use.individual firm could not charge the price more than the market price level. In the beginning price and output 102 . in the short run. Market price will increase only if there is upward shift in the market demand curve. Besides. new firms can neither enter the industry nor the existing firms can leave it. 4. Therefore a separate analysis has been made for these time periods.3. Price and output determination under perfect competitive market in the short run is quite different from that in the long run.1.3 Price and Output Determination under Perfect Competitive Market. An individual firm could sell its product at the higher price only if there is increase in the market price level. Figure 4. Whereas in the long run firms can adjust their scale of production according to the changing demand conditions. in the long run new firms can enter the industry and also existing firms could exit the industry depending upon the profit level in the industry.

103 . As already discussed. The short-run production decision in perfect competition is illustrated using the figure 4. is motivated by profit maximization.2. The firm has to adjust output according to its cost condition. An individual firm is a price taker that is it has to accept the prevailing price as given datum. Market price is determined by the market demand and market supply forces. Some firms may be earning normal profits. etc. cost conditions. based on price. The firm chooses to produce the quantity of output that generates highest possible level of profit. The analysis of short-run production by a perfectly competitive firm provides insight into market supply. An individual firm is said to be in the equilibrium when it attains the maximum possible profit level. The key assumption is that a perfectly competitive firm.determination in the short run is described followed by long run price and output determination. production technology. It attains the maximum possible profit level at the point where Marginal Cost (MC) equals Marginal Revenue and MC is cutting the MR curve from the below. It is worth to note that in the short run each firm need not necessarily earn the normal profit. some super normal profit or even some may be incurring losses depending on their cost functions. firms making supernormal profit and maximum losses can coexist along with the short run equilibrium of the Industry. like any other firm. This means.

if the market price increases profit level of the firms increase. some super normal profit or even some may be incurring losses but industry is said to be in the equilibrium if there is no tendency for its total output to expand or to contract. Short-run Marginal Cost (SMC) curve of the firm B intersected its Short-run Marginal Revenue (SMR) curve at the point E (in the panel B of the figure). At this output level Short-run Average Cost (SAC) per unit is MA whereas Average Revenuer per unit is ME. Firm C producing ON amount of output because its SMC curve intersects its SMR curve at the point E (in panel C). The total amount of profit is (AE * OM) indicated by the shaded area BAPE. Therefore. Therefore it is producing OM level of output.Figure 4. For the given cost conditions. In other words on an average firms should earn normal profit. Thus. The total loss incurred by the firm C is indicated by the shaded area PELS. there is positive relationship between price and supply level. Since it’s SAV is greater than SAR the firm incurring the loss. in the short run some firms may be earning normal profits.2 (panel A) Market equilibrium price OP is determined by the intersection of market demand curve (DD) with market supply curve (SS) at the point E. If there is supernormal profit it 104 . the firm B earning AE amount of profit per unit.2 Price and Output Determination Under Perfect Competitive Market In figure 4. All the firms in the industry have to accept this price level and make adjustment in their output level according to their cost conditions. Therefore.

attract the new firms to the industry contrary if it incur loss it encourage the existing firms to quit the industry. Firms operating in market structures that do not equate price and marginal cost. This relation is generated for two reasons: • • First. the marginal cost curve is not the supply curve for the firm. a perfectly competitive firm's marginal cost curve is also its supply curve. In particular. Short time period does not permit the new firms to enter the industry and also existing firm could not quit the industry. is positively sloped. Therefore. but rather equate marginal revenue and marginal cost. could not earn super normal profit and also there is no inevitability for them to incur the loss in the long run. the supply curve for a perfectly competitive firm is positively sloped. This conclusion. all the firms together. a perfectly competitive firm produces the quantity of output that Second. 105 . earn supernormal profit or even they may incur heavy loss depending on the demand condition. guided by the law of diminishing equates price and marginal cost. In the short run. Taken together these two observations indicate that a higher price entices a perfectly competitive firm to increase the quantity of output produced and supplied. On the other hand if there is heavy loss in the industry as a whole some of the firms which are incurring heavy loss will gradually quit the industry which results in gradual disappearance of heavy loss in the industry. on an average. But in the long run industry as a whole. the marginal cost curve. as already explained above. however. marginal returns. In particular. A key implication obtained from the short-run analysis of perfect competition is positive relation between price and the quantity of output supplied. As such. firms could adjust their output level only by varying the variable input use level. If there is super normal profit in the industry new firms will rush into the industry resulting gradual disappearance of supernormal profit. in the short firms under perfect competitive condition could. only applies to perfect competition.

meaning no firm is inclined to enter or exit the industry. the minimum of the long run average cost curve. • The second is the pursuit of profit maximization by each firm in the industry.4. Economic profit is zero and there are no economic losses. Monopolies are characterized by a lack of economic competition for the goods or service that they provide and a lack of viable substitutes. Thus Monopoly is defined as Market situation where there is only one provider of a kind of product or service. With price equal to average cost. With price equal to marginal cost. This ensures that firms produce the quantity of output that equates price (and marginal revenue) with short-run and long run marginal cost. each firm in the industry earns only a normal profit. a perfectly competitive industry reaches equilibrium at the output that achieves the efficient scale of production. Since monopolist produce unique product there is no close substitute for the product.In the long run. The cross elasticity of demand with every other product is almost zero. The first is entry and exit of firms into and out of the industry. in a 106 . Monopoly should be distinguished from the cartel. that is. each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. This ensures that firms earn zero economic profit and that price is equal to average 4. to sell. with all inputs variable. This is achieved through a two-fold adjustment process. • cost. one + polein. The end result of this long-run adjustment is: P = AR = MR = MC = LRMC = AC = LRAC This condition means that the market price (P) (which is also equal to a firm's Average Revenue (AR) and Marginal Revenue (MR)) is equal to Marginal Cost (MC) (both short run and long run) and Average Cost (AC) (both short run and long run). In a monopoly a single firm is the sole provider of a product or service. Monopoly The term Monopoly derived from the Greek monos.

technological.1.cartel a centralized institution is set up to partially coordinate the actions of several independent providers. or of some other type of barrier that completely prevents other firms from entering the market 4.4. Primary Characteristics of a Monopoly • Single Seller: A pure monopoly is an industry in which a single firm is the sole producer of a good or the sole provider of a service. • Unique product/No Close Substitutes: The product or service is unique in ways. which go beyond brand identity. Monopoly firm could not determine the price and quantity simultaneously. If it fixes the price for his product buyers determine the quantity that they are willing to buy at that particular price level. It is not meant that monopoly firm is some thing like dictator in the market. Forms of Monopoly Some important forms of monopoly are discussed here under: 107 . by changing the quantity supplied. and cannot be easily replaced. • Blocked Entry: The reason a pure monopolist has no competitors is that certain barriers are kept for new firms to enter the market. 4. Depending upon the form of the monopoly these barriers can be economic. This is usually caused by a blocked entry. • Price Maker: In a pure monopoly a single firm controls the total supply of the whole industry and is able to exert a significant degree of control over the price. legal (basic patents on certain drugs).2.4.

What distinguishes the monopolist from the perfectly competitive firm is that the latter is a price taker. When such a monopoly is granted to a private party. Whether an industry is a natural monopoly may change over time through the introduction of new technologies. • Natural monopoly: A natural pool is a monopoly that arises in industries where economies of scale are so large that a single firm can supply the entire market without exhausting them. Price and Output Determination under Monopoly In monopoly we have just one firm in the industry. usually a town or even a smaller locality: the term is used to differentiate a monopoly that is geographically limited within a country. • Local monopoly: A local monopoly is a monopoly of a market in a particular area. it is a government monopoly. which arises typically in network industries such as electricity and railway. when government itself operates it. while the former is not. it is a government-granted monopoly. A businessman with monopoly power can choose the price he wants to sell 108 . In these industries competition will tend to be eliminated as the largest (often the first) firm develops a monopoly through its cost advantage. Coercive monopoly: A coercive monopoly is one that arises and whose existence is maintained as the result of any sort of activity that violates the principle of a free market and is therefore insulated from competition. as the default assumption is that a monopoly covers the entire industry in a given country. Natural monopoly arises when there are large capital cost relative to variable cost. Government can also artificially break up a natural monopoly industry.3.g.4. just for one region or locality or State). electricity liberalization). although (e. which would otherwise be a potential threat to its superior status 4.g. A government monopoly may exist at different levels of government (e.• Legal monopoly: A monopoly based on Laws explicitly preventing competition is a legal monopoly or de jure monopoly.

Buyers are prepared to buy the entire OM level of output if the firm fixes the price OP.3. is producing OM level of output. Thus. The total net income or profit earned by the firm is shown by the shaded area i. in other words. We often assume that the demand curve is linear P= a-bq Where p is price and q is quantity sold. this line meets the demand curve at point S. because the demand curve he faces is the market demand curve. This can be explained with the help of the figure 4. Price and Output Equilibrium under Monopoly 109 . To find out which price-output combination maximizes the monopolist's profits we need first to explore the implications of its downward-sloping demand curve. monopolist produce the output at the point where its Marginal Cost (MC) curve intersect the MR curve from the below.4. If he sets it lower. the monopolist can exert some influence over the market price. This contrasts with the horizontal demand curve facing the perfectly competitive firm. an Average Revenue (AR) curve. Therefore. This difference in the demand curve is what distinguishes monopoly from competition. When the AR curve is downward sloping Marginal Revenue (MR) curve will also slopes downward but the rate of slope of the latter is faster than the former. It shows that the consumers are prepared to buy this level of output at the price level OP. the firm is earning TS amount of net income per unit. This together with cost conditions determines the profit level of monopolist. Figure. If he sets it higher. which is downward-sloping. HTSP.3. It could be understood by drawing a straight line from point M on the horizontal axis towards the demand curve. From the point of view of the firm a demand curve indicates how much it can charge for each unit of output varies as its output varies. Here. he sells less. The price (AR) level for any given output level is determined on the basis of demand condition. At this level of output Average Cost (AC) per unit is MT where as the Average Revenue (AR) is MS per unit. therefore. The demand curve is.e.at. The firm. In order to maximize the profit level. downward-sloping demand curve. The Marginal Cost (MC) of the firm intersects its Marginal Revenue (MR) curve at point E. he could sell more. This gives a straight line.

• Product Differentiation: A general class of product is differentiated if any significant basis exists for distinguishing the goods of one seller from another. 4. Characteristics of Monopolistic Competition This market condition possess the following characteristics: • Large number of sellers: As in the perfect competitive market. there will be large number of sellers in the monopolistic competitive market. Monopolistic Competition refers to competition among large number of sellers producing and selling close but not perfect substitutes.5.1.5. No seller by changing his price and output policy could have any perceptible effect on the sales of others as in the oligopoly market.4. Monopolistic Competition Perfect competition and Monopoly are extreme cases. Product differentiation may be by: a) quality 110 . Such basis may be real or imaginary. which are seldom found in practice. But monopolistic competition and Oligopoly market situation could be very widely found in practice.

5. the nature of the product. • Nature of Demand curve: The demand curve of an individual firm under monopolistic competition slopes downward from left to right. under monopolistic competition. in this market demand is highly elastic but not perfectly elastic. a firm under monopolistic competition has to decide about its price policy. in contrast to perfect competition.of product such as durability. that is. with the exception of the heterogeneous products. • Freedom of entry and exit: Individual firms/sellers and buyers are free to enter or leave the market as in the perfect competitive market. Thus. or b) advertisement. owing to brand loyalty. This gives the company a certain amount of influence over the market. design etc. the nature of its product and the sales promotion outlay it makes. The market of an individual firm under pure competition is completely merged with the general one. it can raise its prices without losing all the customers. individual firm’s market is isolated to a certain degree from those of its rivals with the result that its sales are limited and depend upon price.2 Price and Output Determination under Monopolistic Competition. shape. What price should it charge for its product? Because of the attachment of some consumers to its particular brand or the product. elasticity of demand is in between the two. the characteristics of a monopolistically competitive market are exactly the same as in perfect competition. it has some monopolistic influence over 111 . Firstly. the firm under monopolistic competition has to confront a more complicated problem than the purely competitive firm. it can sell any amount of the good at the ruling market price. size. This means its demand curve is downwards sloping. But. That is. in regard to the price. Equilibrium of an individual firm under monopolistic competition involves equilibrium in three respects. and the amount of advertising outlay it should make. In this market condition. 4. In the preceding section you have understood that in the perfect competitive market demand curve for an individual firm is perfectly elastic whereas in monopoly market it is relatively inelastic. which could create imaginary uniqueness in the product. Thus.

The selling outlay changes the demand for his product as well as his cost. sales depend upon the skill with which the good is distinguished from others and made to appeal to a particular group of buyers”. depends in part upon the manner in which its product differs from others. a new design. If it raises the price of its product a little. it will be able to sell less. a firm under monopolistic competition has to adjust the amount of his expenditure on sales promotion in such a way as to maximize his total profit. 112 . Like the adjustment of price and product. if it reduces its price. Therefore. the demand curve confronting a firm under monopolistic competition is not a horizontal straight line. it may mean new package or container. If it sets a higher price. better materials. as explained above. it may lose many of its customers but not all. Thirdly. The elasticity of demand curve for any of them depends upon the availability of the competing substitutes and their prices. The variation of the product may refer to an alteration in the quality of the product itself. a different way of doing business. the firm will try to adjust its product so as to confirm more to the expectation of the buyers. The profit maximisation principle applies to the choice of the nature of the product as to its price. The expenditure incurred on advertisement is prominent among the various types of sales promotion expenditure. “Where the possibility of differentiation exists. but a downward sloping curve. if it sets a lower price it will be able to sell more. The amount of the product. it may also mean more prompt or courteous service. or perhaps a different location. is downward sloping. which a firm will be able to sell in the market. Secondly. The problem of adjusting his selling outlay is unique to the monopolistic competition. a seller under monopolistic competition can influence the volume of his sales by varying the amount of expenditure on sales promotion. Since the various firms under monopolistic competition produce products which are close substitutes of each other. On the other hand. The demand curve for the products of an individual firm. The firm will choose that price-output combination which yields maximum total profits. it may attract more customers of his rivals.the price of its product.

conditions regarding availability of substitute products and their prices are assumed to be constant while the equilibrium adjustment of an individual firm is considered in isolation. Figure 4. In this figure Marginal cost curve (MC) intersects the Marginal Revenue (MR) at point E. indicates the total profit level at this level of output. therefore.6. However. AR or demand curve for an individual firm under monopolistic competition is almost similar to that in the monopoly market condition but the only difference is that the AR curve under the former is bit flatter than that in the latter. When the average revenue slopes down ward marginal revenue will also decline but at the faster rate than the former. could earn SQ amount of profit per unit. 4. for the sake of simplicity in analysis.4. The firm. therefore. With the assumptions. Equilibrium of a Firm Under Monopolistic Competition AR and MR are average and marginal revenue curves respectively. Thus. It means the elasticity of demand is more in monopolist competitive market compared to the Monopoly market.4. At this level of output Average Cost (MS) is less than the Average Revenue (MQ). The shaded area RSPQ. produces the OM level of output in order to earn maximum possible profit. When it produces the OM level of output it could sell it at the MQ (OP) price. OLIGOPOLY 113 .Therefore equilibrium adjustment of an individual firm cannot be explained in isolation to the general field of which it is a part. an individual firms equilibrium/production level and price adjustment could be explained with the help of the figure 4.

If products of few sellers are homogeneous. • High Cross Elasticity of Demand: The firms under oligopoly have a high degree of cross elasticity of demand for their products. • Advertisement: Advertising and selling costs have strategic importance to oligopoly firm. then market referred to as differentiated oligopoly. although each is dependent on the market. 4. Where as if products of few sellers are differentiated.6. then market referred to as pure oligopoly. There will be always the fear of retaliation by rivals.Oligopoly is a market condition. which is most prevalent in majority of the industrial countries. But unique feature of the oligopoly market is that the policy of every producer directly affects each other due to few number of firm and close substitutability of the goods. This is a market situation where few sellers involved in selling homogeneous or differentiated products.1 Features of Oligopoly • Few sellers: Oligopoly is a market situation in which the number of sellers dealing in homogeneous or differentiated product is very small. • Uncertainty: Lack of certainty is another important feature of oligopoly market condition. 114 . • Interdependency: In perfect competition. Under this market condition it is difficult to analyse the effect of price change initiated by a firm on its own sales due to uncertain reaction by his rivals. monopoly and monopolistic competition each firm is more or less independent of the other. Some important features of this market condition are discussed under the following section. Each firm tries to attract the consumers towards its product by increasing expenditure on the advertisement. It is often referred to as “competition among the few”.

4.6. Independent pricing refers to the independent action of each seller within an oligopoly industry. making this part of the demand curve relatively elastic (flatter). Thus gradually all the firms understand the futility of the price war and desire for the price stability. 115 . Price war harms all the firms in the industry. Price Rigidity/Kinked Demand Curve: Oligopoly price that remains stable over a period of time are called rigid price. Under independent pricing behavior each and every firms try to maximize their profit. The theory aims to explain the price rigidity that is often found in oligopolistic markets. its rivals will be forced to follow suit to prevent a loss of market share.• Nature of Demand Curve: Due to inter dependency the nature of demand curve is unique under this market condition. His rival apprehending a reduction in their sales retaliate and each tries to undercut the others.6. making this part of the demand curve relatively inelastic (steeper). Broadly there are three types of pricing behavior viz. 4. Such an independent pricing behavior may result in price war or price rigidity.2: Price and Output Determination under Oligopoly Market: No unique pattern of pricing behavior exists in the oligopoly market due to interdependency among the firms. The firm that increased its price will find that revenue falls by a proportionately large amount. firms in an oligopoly market have a kinked demand curve. as keeping their prices constant will lead to an increase in market share. Lowering price will lead to a very small change in revenue. According to Paul Sweezy. Price rigidity is also popularly known as Sweezy Model. cartels and price leadership. 4.1 Price War: Price war may start when one seller reduces the price of his product line in order to increase his sales. Such desire gradually leads to price rigidity. Independent pricing. It assumes that if an oligopolist raises its price its rival will not follow suit.2. Since each firm trying to maximize their profit it create rivalry among the firms.6. Because this model was developed in the late 1930s by the American Paul Sweezy. Conversely if an oligopolist lowers its price.2.2.

the price rigidity could be attributed to the following reasons • • • Individual sellers may understand the futility of price war and thus prefer price stability They may be content with the current price. output and profits and avoid any kind of unnecessary insecurity and uncertainty. There is discontinuity in Marginal Revenue curve at the corresponding position i.e. it becomes ED.and the profit.g..On the other hand it decreases its price rivals will follow it thus its demand curve become inelastic i. Prices will further stabilize. 116 .The firm then has no incentive to change its price. Therefore. MC0 to MC1 (between prices a and b).e A to B. Figure 4. demand curve is kinked at point E.e.5. They may view non-price competition better than price rivalry. as the firm will absorb changes in its costs as can be seen in the figure 4. it will become R1E. If the firm increases its price its rivals will not follow hence its demand cure become more elastic i.5. as it will lead to a decrease in the firm's revenue.e. Kinked Demand Curve In this figure let us assume that the original price is OP. The firms may intensify their sales promotion efforts at the current price instead of reducing it. In the light of this. This causes the demand curve to kink around the present market price. The marginal revenue jumps (vertical discontinuity) at the quantity where the demand curve kinks. the marginal cost could change greatly .

4. 4. The cartels. Pricing policies and methods in practice is focused in this 117 .2. There will be tactics agreement among the firms to sell the products at a price set by the leader of the industry. Perfect cartel is an extreme form of perfect collusion. In this section an attempt has been made to explain how firms in the real world set the prices. There are mainly two types of cartels.6. firms producing a homogeneous products form a centralised cartel board in the industry.3. follow common policies relating to prices.4 Price Leadership It is an imperfect collusion among the firms in the oligopoly market. Some times there may be formal meetings and definite agreement with the leader firm.6. The purpose formulation of cartel is to increase the profit level of the member firms by subjecting their competitive tendency to some form of agreement.2. It is a system under which all the firms of an oligopoly industry follow the lead of one of the big firm (Leader). Ultimately. form the cartels. 1) Perfect cartels or Joint profit maximisation 2) Market sharing cartel. The individual firms surrender their price output decisions to this central board. Whereas in the market sharing cartel the firms enter into market sharing agreement to form a cartel but keep a considerable degree of freedom relating to price and output decisions. Under this system leader initiate the price change and then follower firm accepts the price change and make corresponding output adjustments. These cartels may be voluntary. opened or even it may be secrete depending upon the policy of the government relating to cartels.7 RICING POLICIES The previous sections of this chapter mainly dealt with the theoretical framework for the pricing decisions. In this. normally. Cartel Under oligopoly market condition firms may. sales and profit. It is the kinked demand curve.• • After spending lot of money on the advertisement a seller may not like to raise the price of his products to deprive himself of the fruits of his hard labour. A cartel is an association of independent firms within the same industry. which is responsible for the price rigidity. gradually. compulsory. 4.

fall short of what it could be.1 Factors Involved in Pricing Policy In economic theory. a seller may price himself out of the market. buyers and sellers. In practice however. potential rivals.7. i. his income may not cover costs. i. direct or variable costs have greater relevance. is the source of revenue. It has to set its own price policy. setting prices is a complex problem and there is no clear-cut formula for doing so. The firm has a pricing problem.. a manufacturing firm today operates under imperfectly competitive market condition. and hence it has to set its own price policy. rival sellers. cost analysis is important. Economy in cost is also important for setting a lower price for the product.section. Cost data serve as the base. it is the most important device a firm can use to expand its market. Certain general considerations. If it is too low. as may be feasible. which must be kept in view while formulating the pricing policy. in fact. 4.e. If the firm is operating under perfect competition it acts only as price taker and there is hardly any choice left. only two parties are generally emphasized. The firms seek to cover full-allocated costs. However. Usually. or at best. when there is imperfect or monopolistic competition. which the firm seeks to maximize. All these parties also exercise their influence in price determination. Again. 118 . • Costs: Cost is an important element in price determination. Whether to set a low price or a high price would depend upon a number of factors and wide variety of conditions. Price. as pointed out by Oxenfeldt. middle men and government. certain other parties are also involved in the pricing process.. Thus. Along with the total costs. Formulating price policies and setting the price are the most important aspects of managerial decision-making. Under monopoly the firm is a price maker. A high cost of production obviously calls for a higher price. are given below: • Market Structure: Pricing policy is to be set in the light of competitive situation in the market. For business decisions in the short run. average and marginal costs are to be determined.e. If the price is set too high. If price is below the cost of production it would mean losses.

Very often companies fix a target rate of profit. profit consideration is also significant. In practice. The various objectives may not always be compatible and hence the need for their reconciliation. Through appropriate advertising and sales campaign consumers’ psychology can be influenced and their preferences may be altered.. In case of elastic demand for the goods. are the firm’s overall objective. In some cases. 119 . So. A pricing policy should never be established without full consideration as to its impact on the other policies and practices of the firm. TV set. • Objectives of business: Pricing is not an end in itself but a means to an end. in all cases demand is not price elastic. Usually. rarely there is a goal of profit maximization. when income of the buyers rises. Demand for a firm’s product depends on consumer’s preferences. a price cut would be beneficial in boosting the sale. i. Further. demand can never be overlooked. the consumer psychology is very important. as far as possible. however. price rigidity may be the norm of the price policy. demand is income elastic. demand is more important for the effective sales.• Demand: In pricing policy. will depend upon the forces of competition. Thus demand can be manipulated.e. • Profit: In determining price policy. Rather. pricing policy is based on the goal of obtaining a reasonable profit. Whether the company will be able to achieve the target rate of profit. But. The broadest of these is survival. Further. the firm can expect to sell more such goods even at high prices. Thus. rigidity does not mean inflexibility. then only rising price policy would be a paying proposition to the businessman. Thus. therefore. Price fluctuations do conform to cost changes. The fundamental guides to pricing. most of the businessmen would prefer to hold constant price for their products rather than going for a price rise or a price cut. If demand for the product is highly inelastic. especially. consumer durables. car. etc. A low or high price policy is to be set considering the elasticity of demand.

For instance. The various factors which may generate insensitivity to price changes are variation in the effectiveness of marketing effort. Thus.7. the manufacturer would desire that the middleman should sell his product at a minimum mark-up. importance of service after sales which have to be taken into account while formulating the pricing policies. The firm’s overall objectives serve as guiding principle to pricing. in these days of monopolistic competition or dynamic changes and business uncertainties. Empirical evidences reflect that theoretical goal of profit maximization is rarely taken in practice by the business firms in their price policy. in India we have drug price control. the firm has to adopt the price as per the formula and ceiling prescribed by the Government. then there is little scope to pursue its own pricing. The following are the commonly adopted major pricing objectives of a business firm: • Survival: basically. etc 4. whereas the middleman would like his margin to be large enough to stimulate him push up the product. which tend to minimize it. • Conflicting Interests of Manufacturers and Middlemen. Therefore. sales promotion programmes and other such elements have to be considered while formulating the pricing policies. firm’s business objectives are normally spelled out as the objectives of its price policy.• Product and Promotional Policies: Pricing is only one aspect of market strategy and a firm must consider it together with its product and promotional policies. The interests of manufacturers and middlemen through whom the former often sell are sometimes in conflict. the firm must explicitly lay down its pricing objectives.2. • Government Policy: Pricing policy of a firm is also affected by the government policy. Objectives of Pricing Policy Pricing is not an end in itself. For instance. If the government resorts to price control. • Nature of Price Sensitivity: Businessman often tends to exaggerate the importance of price sensitivity and ignore the many identifiable factors at work. a firm is always interested in its continued 120 . The quality of the product. Pricing is a means to an end. nature of the product.

• Maximization of profits for the entire product line: As Kotler has pointed out. • Market Penetration: Here. it may fix up the price such that would prevent competition. • Market Shares: By adopting a price policy the firm may wish to capture a larger share in the market and acquire a dominating leadership position. organizational and even personnel changes. For the sake of assuring continued existence. So. the firm may keep an eye on rival’s entry. • Early Cash Recovery: Some firms try to set a price. which will enable rapid cash recovery as they may be financially tight or may regard future as too uncertain to justify patient cash recovery. Thus a firm may pursue the promotion of the longrange welfare of the firm • Rate of Growth and Sales Maximization: A firm may be interested in setting a price policy. relatively low price may be set to stimulate market growth and capture a large share thereof. firms set price. generally. Thus it is the fundamental duties of the firms to fix the 121 .survival. 4. a firm is ready to tolerate all kinds of upheaval in product lines. • Market Skimming: Here.3 Pricing Methods In Practice In the real world most of the business organisaitons are operating their business under imperfect competitive condition.7. high initial price is charged to take advantage of the fact that some buyers are willing to pay a much higher price than others as the product has high value to them. which will permit a rapid expansion of the firm’s business and its sales maximization. • Preventing Competition: In pricing its product. which would enhance the profit from the entire product line rather than yield a profit on one product only.

Full cost pricing method is being very widely adopted by the firms. There is no clear-cut criterion to select a particular pricing method. Limitations of Full Cost Pricing Method Though it is relatively easy to adopt this method of pricing it is having certain limitations. • Full-cost pricing offers a means by which fair and plausible prices can be found with ease and speed.1. This makes it too risky to move away from full-cost pricing • A major uncertainty in setting a price is the unknown reaction of rivals to that price. It does not reflect market forces. among member firms. • Firms preferring stability use full cost as a guide to pricing in an uncertain market where knowledge is incomplete. Uncertainty could be minimized to some extent. rate of returns. 122 . This is mainly because.suitable price for their products in such a way as to fulfill the overall objective of their organization. • • It ignores demand – it does not care for what people prepared to pay. naturally the profit percentage differs among industries. the price is set to cover costs and a predetermined percentage of profit. cost base. which suits their objectives. risk etc. • In practice. Cost-Plus or Full-Cost Pricing Under this method. Some of the important pricing methods that are being practically adopted by one or the other firm are discussed below: 4. Numbers of pricing methods have evolved over the period. Most important limitations of this method are. firms are uncertain about the shape of their demand curve and about the probable response to any price change. The profit percentage will be determined on the basis of intensity of competition in the market.7. no matter how many products the firm handles. cost-plus pricing yield acceptable profit to most other member so the industry also.3. When products and production process are similar. But any business organization will adopt the pricing method.

Number of seats = 160. If flight not full. fixed cost considered to be ignored and prices are determined on the basis of marginal cost. It Allows variable pricing structure – e.3. average price = £93. Under the rate of return pricing policy.50 and fill the seat than to fly with empty seats.7. Marginal Cost Pricing Pricing methods discussed above are based on the total cost of production. In such situation Marginal cost pricing method is suitable. on a flight from London to New York – providing the cost of the extra passenger is covered. Rate of return pricing is a refined method of full cost pricing. 123 . for instance. pricing is based on cost. Under the marginal cost pricing. Under this method price is to be fixed based on the marginal cost of production.000 is fixed cost. The profit margin is determined on the basis of normal rate of production. 4.75. Thus. price is determined along a planned rate of return on investment. 4.000 of which £13. a firm may set its price of the product in order to get on an average a 8 per cent return on net investment. It is the cost of producing ONE extra unit of production. as per the accounting approach. Marginal cost is the addition made to total cost by producing an additional unit of output. The rate of return is to be translated into a percent mark-up as profit margin on cost.• Full cost pricing ignores marginal or incremental costs and uses average costs instead. Rate of Return Pricing In this method the firms determine the average profit mark-up on costs necessary to produce a desired rate of return on its investments say. MC of each passenger = 2000/160 = £12. Thus.50. better to offer last passengers chance of flying at £12. it has the same inadequacy as the full cost pricing method.g.2. Naturally. it allows flexibility in pricing.7. which may not relevant to the pricing decision. It could be explained with a numerical example. In Aircraft flying from Bristol to Edinburgh – Total Cost (including normal profit) = £15.3. the price could be varied a good deal to attract customers and fill the aircraft. It is most appropriate method in the industries where fixed cost is relatively high.3.

In case of price leader. This method is generally suitable to the new products or to launch the product into a new market. However. 4. electrical goods – find very similar prices in all outlets It must be noted that going rate pricing is not quite the same as accepting the price impersonally set by near perfect market.3. 4. Going Rate Pricing. Thus. rivals have difficulty in competing on price – too high and they lose market share. firms may set relatively lower price in the hope of penetrating into the market. 124 .4. Rather it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences.3. It is typical in mass-market products. charging according to what competitors are charging may be the only safe policy. It is a method under which relatively low price is set in order to penetrate into the new market. The idea is to establish a market share first and than gradually move to a price which is more desirable from the profit angle. Going rate-pricing policy found to be a rational method where it is difficult to estimate the different cost of production. Where price leadership is well established.3. Penetration Price. While introducing new products or entering in new geographical market. Where competition is limited. petrol. however. supermarkets. too low and the price leader would match price and force smaller rivals out of market. Under this method firms adjust its own price policy to the general pricing structure in the industry.5. It prefers. It is a kind of price leadership.7.7.4. to take the safe course and confirm to the policy of others. this strategy works well provided the demand is highly price elastic and the nature of the product differentiation is such that many customers are in a position to get attracted by low price. ‘going rate’ pricing may be applicable – banks. Skimming Price.7. Going rate reflects the collective wisdom of the industry. it is the Price set to ‘penetrate the market’ and ‘Low’ price to secure high volumes.6.

the government intervenes and fixes the price at which the producers sell those products. after a patent runs out). Public utility concerns are managed by the government with the objective of providing services to the people at reasonable price.3. It is method under which goods/services deliberately sold below cost to encourage sales of the other products. while fixing the price the government will consider the cost of production and also fair returns to the producer. Examples include: Play station. new DVDs. the producers may charge heavy price. The price should not be prohibitive. A firm selling both razor and blade may charge the price of razor.g. which should be strictly followed by the producers. The major limitation of this method of pricing does not allow the free play of market forces like supply and demand. jewellery. etc 4. The rationality behind this method is that the essential commodities have to be made available to the people at reasonable price. 4. Each successive fall in price may bring in more and more customers.7. Administered Price.7. However. Administered price is the price. which prevents the weaker section to purchase them. Loss-Leader Pricing. this pricing method is loosing the importance.7. Even in case of essential commodities produced in private sector. In such situation it is the duty of the government to make products available at fairly reasonable price to the consumers.8. Due to the liberalised economic policy. But there is danger in letting the price to fall beyond a point because of the perceived correlation between price and quality.It is a pricing method under which the firm starts with a high price appealing to those customers who are willing to pay higher price for better quality or because they put some additional value on the products.3. In this method government fix the price for the products. at the latter stage a slightly falling price may attract the new customers. which is below the average variable cost if it is confident of selling a large volume 125 . If they become monopoly products. This method is suitable for products that have short life cycles or which will face competition at some point in the future (e. which is fixed by the government and is mandatory in character. However. digital technology.

there are many different pricing methods. Requires different price elasticity of demand in each market Thus. Best example for this method is electric Power. customers are induced into buying other complimentary items in the line and the whole set becomes profitable. policy? 6. e. selling bottles of Gin at £3 in the hope that people will be attracted to the store and buy other things. curve 7.9.8.g. which are being practically adopted by one or the other kind of firms. Self Review Questions 1. 3. domestic users. Such a pricing strategy is suitable even in the capital goods with heavy requirement of the replacement parts and consumables. In other words firms charging a different price for the same good/service in different markets. 4. commercial users etc. In this method. the same product will have different price in different market segments. 5. Explain the features of monopolistic competition What is kinked demand curve? Explain the reasons for kinked demand What is market? How markets are classified? Distinguish monopoly and monopsony Define oligopoly What is penetrating price? When this pricing strategy is suitable? Define discriminating price? What are the conditions required to adopt this 126 . 2. However. It is typical in supermarkets. industrial units.7. Electricity board will charge different price to the same power to different power users like agriculturists. 4. its adoption requires each market to be impenetrable.of the blades in order to over compensates the loss in the razor.3. Discriminating Price. at Christmas. Because of the loss making product. 4. However. while choosing a particular pricing method a firm has to carefully analyse which method is suitable in perusing its objectives.

New Delhi 2. New Delhi-110002 MODULE-V: PROFIT ANALYSIS 127 . Singapore 5. S.Chand & Company Ltd.8.L: “Managerial Economics”.G. and Appanniah. Tata McGraw-Hill Publishing Company Limited. New Delhi110 055 6.: “Advanced Economic Theory”. Gupta. Ahuja. S: “ Managerial Economics: Concepts and Cases”. H. 11. R. market 9. and Maheshwari K. H.9.M.Mithani : “Managerial Economics: Theory and Applications”. 4. 10. References/ Suggested Readings 1. L. Reddy. Himalaya Publishing House. Mumbai-400 004 3. Describe the price and output determination under perfect competitive Explain the pricing problems in oligopoly market condition Discuss the factors involved in pricing policies Explain the different pricing methods that are being practically followed by the business organistions. Mote. N. Varshney RL. : “Principles of Business Economics”. Samuel Paul.. S. Sultan Chand & Sons. Dominick Salvatore: “Managerial Economics”. New Delhi-110 055 4. V. L. McGraw-Hill International Editions.Chand & Company Ltd. D.P.

The understanding of this tool equips the management students in the profit planning of a firm. Though profit is an income for the entrepreneur for his work. as it is the reward for the entrepreneur who undertakes the work of coordination of the factors and produces the commodity.1 Meaning and Nature of Profit In economic theory. it is the reward for taking risk in business. It is the difference between the total sale proceeds obtained and the total expense of production. Contrary to it Joel Dean is of the opinion that “A business firm is an organization designed to make profits. However. profits have become a mixed income. In the absence of profits. The last section of this module deals with linear programming approach. Prof. Since the entrepreneur gets his income in a variety of ways. Management students need to have proper understanding about the concept and measurement of profit. This module deals with the break-even analysis also. 128 . as there is no unanimity among economists about the definition. Profits when compared to other rewards of factors. is vitally important. 5. Karl Marx has condemned profits as predatory income. as wages of management or it is the reward for entrepreneur. Profit is the percentage of return on investment. It is also a vexed one. It is a residual income for the entrepreneur after paying off other factors. he is getting the income called profits. It is also a reward for ownership of capital. Thus the term profit has been interpreted in a variety of ways. branding it as legal robbery. profits are payments for the work of the entrepreneur. which is most useful in optimization decisions. But this concept of profit has become a vexed and mixed one. as he is a factor of production like other factors. That is why.Profit is one of the main motives behind any kind of business activities. Knight has observed “no term or concept in economic discussion is used with a more bewildering variety of well-established meaning than profit”. So. and profits are the primary measure of its success. there would not be incentive for production and profits act as a source of capital formation and economic progress. Profits have been defined.” and this brings the importance of profit in the context of managerial decisions. this chapter focuses on the concept of profit.

These are wages. These are as follows: 129 . Economists think that in addition to these. The economists. Profiteering is a deliberate attempt to earn extra profits at the cost of even business ethics. For the better understanding of the concept of profit one should understand the difference between ‘profiteering’ and profit earning. as he brings the three factors of production together for producing some consumable commodity. profit is regarded as the revenue realized during the period minus the cost and expenses incurred in producing the revenue. Similarly one should have the better understanding about the difference between ‘accounting’ and ‘economic profit’. Economists consider both explicit and implicit costs in arriving at profits.Theoretically. They deduct both explicit and implicit costs from the total sales receipts in determining profits. The term ‘Profiteering’ is different from ‘Profit-earning’. taxes paid and other sundry expenses. The former connotes “earnings which are excessive and beyond the socially desirable and acceptable limit by questionable methods”. But in the case of Modern Corporation. Profit earning. According to Accountants. money-cost of production. As a result. These items together constitute Explicit costs of production. which ought to be included in the term. Hoarding is one prominent way of profiteering. or the Joint-stock Company. however. or the salaried managers who undertake entrepreneurial functions? Vera Anstey believes that the term should cover both these groups. This concept of profit is also known as Residual Concept. In the accounting sense. There is a wide difference between profit in the accounting sense and profit in the economic sense. the definition of profit is that the reward for the entrepreneur is acceptable. do not agree with the accountant’s approach to profit. on the other hand denotes making profits within socially desirable and acceptable limit. rent. interest. there are other items. who should be identified as the entrepreneur? Is it the equity shareholders who undertake the risk of investing their money. Profiteering is socially unjust. depreciation charges on fixed capital. Profit is the result of variety of influences in a business. the money-cost of producing an article includes only those costs which are directly paid out or accounted for by the producer. many theories of profits are emerged.

it is an easy and 130 . Rent on land and buildings belonging to him and used in productions. when the firm is in no profit and no loss position. it means that the firm is making revenue equal to the total of accounting and implicit costs and no more. Such profits are considered usual or normal in the line of business. • They indicate the effectiveness of business efforts: The success or effectiveness of the business is indicated through the profit it earns. for managerial purposes. A business firm may be making profits in the accounting sense. Hence. as they truly reflect the profitability of a business concern. Interest on capital supplied by him. The firm will be earning Economic Profits only if it is making revenue in excess of the total of accounting and implicit costs.• • • • Wages for the work performed by the entrepreneur. Peter Ducker. but it may be actually incurring losses in the economic sense. Such a firm will not survive in the long run. Even though it may be argued that profit is not a perfect measure of business efficiency. They deduct only explicit or actual costs from the total revenue earned while determining the profits. Economic Profit = Total Revenue – Economic Costs. Accountants do not include these items in determining profit. Functional Role of Business Profits: According to Prof. Economists call them implicit cost of production. business profits play a functional role in three different ways. Higher the profit of concern. Economic cost = Explicit Cost + Implicit Costs Or Economic Costs = Accounting Cost + Implicit Costs. Thus. Economic profits are relevant from the managerial point of view. we generally consider that the business is more successful. Therefore. economic profits are more useful than the accounting profits.

2. obsolescence.2 Theories of Profit There are several theories of profit propounded by economists. None of these deal with all aspects of profit. Only uninsurable risks are real risks. etc. Insurable risks are no risk at all. Business firms must generate profits sufficient to provide for these costs. greater is the possibility of profit. If risk can be insured against. • They provide the premium to cover costs of staying in business: Profit is a source of funds from which a business firm will be able to defray certain expenses like replacement. Business concerns help themselves by generating profits in meeting part of their capital requirement apart from raising funds through extraneous sources. But this theory is criticized on the following grounds: • • • 5. As per this theory. 5. According to him. profits arise because the entrepreneur undertakes the risk of the business and he has to be rewarded for that.2 There is no relationship between risk and profit. fire. Knight. Profit is the result of not only risk bearing. Knight’s Uncertainty-bearing Theory This theory. agrees with Hawley’s theory that profit is a reward for risk-taking. but also due to other factors.2. higher the risk. For instance. marketing. 131 . The latter risk is called uncertainty bearing.1.quick basis on which business performance can be compare among the various firms. advocated by Prof. it is not risk at all. • They ensure supply of future capital: Profits are the principal source for a firm’s future capital requirements for innovation and expansion. 5. the term risk is clarified and there are two types of risks: a) Foreseeable risks. and b) Unforeseeably risks. We shall study some of the theories of profit. Each theory focuses on the different aspects of profit. However. Hawley’s Risk Theory An American economist Hawley advocated this theory.

flood. when there is no question of uncertainty bearing in monopoly? It is not possible to measure uncertainty in quantitative terms to ascribe profit. Technical risk. these risks cannot be foreseen and measured. In this condition. According to this theory. This is because. How do profits arise. which can be insured. in equilibrium. does not give rise to profit. Knight. and the loss arising out of these will be made good by the insurance company. there is a direct relationship between profit and uncertainty bearing. So. theft. namely ownership and control The theory does not explain monopoly profit. Uncertainty bearing is one of the determinants of profit. Dynamic Theory of Profit This theory advocated by J. The theory emphasizes too much about uncertainty-bearing as to elevate it into a separate factor of production This theory does not separate the two functions in modern business.B. what explanation could be given in cases where profits do not accrue in spite of uncertainty bearing. and Risk arising out of business cycle. profit is due to non-insurable risk or unforeseen risk.2. under static conditions payments made to the factors of production on the basis of marginal productivity exhaust the total output. are risks in business. etc. Clark assumes that profits arise as a ‘Dynamic Surplus’. Knight’s theory is criticized on the following grounds: • • • • • • If profits are due to uncertainty bearing.3. they become non-insurable and uncertainties have to be borne by the entrepreneur. in a static state. According to this theory. according to Prof. Risk of government’s intervention. Since. there is no change in demand and supply and profits do not arise. price of each commodity exactly equals its money cost of 132 . and that is not the only determinant. Insurable risk. The premium paid for insurance is included in the cost of production. Some of the non-insurable risks: • • • • Competitive risk.. thus. 5.

including normal profits and there is no surplus of any kind. profit is the reward for innovation. • • Mere change in an economy would not give rise to profits. in a static state. It may be the result of introduction of a new technique or a new plant. it means there is no entrepreneur. According to this theory. This theory has created an artificial distinction between ‘Profit’ and ‘Wages of Management’. which is earned in a static state also. so as to create a gap between the existing price of the commodity and its new cost. if these changes were predictable. It may 133 . But without an entrepreneur. there are no possibilities of getting profit and it arises only in dynamic condition. Hence. If there are no profits in a static state. Marshall solved this difficulty by his concept of normal profit. Therefore. This theory is criticized as follows: • This theory does not fully appreciate the nature of entrepreneurial functions. Profits arise due to disequilibria caused by the changes in demand and supply conditions. • • • • • Changes in the quantity and quality of human wants Changes in the methods and techniques of production Changes in the amount of capital Changes in the form of business organization Changes in population Such changes give some entrepreneurs advantages over other entrepreneurs and they manage to earn surplus. Innovations refer to all these changes in the production process with an objective of reducing the cost of the commodity. Schumpeter’s Innovation Theory This theory propounded by Schumpeter is more or less similar to Clark’s theory.4.production. but this theory gives importance to innovations in the productive process. the question arises what Clark mentions about five changes.2. it is not possible to imagine the coordination of factors of production. It is a dynamic surplus. which may occur in a dynamic economy to give rise to profits. Profits result only when selling prices of goods exceed their cost of production. Schumpeter’s innovation may take any shape. Now. a change in the internal structure or organizational set up of the firm. 5.

When the marginal productivity is high. Profits are caused by innovation and disappear by imitation. Further. Only exceptional entrepreneurs with extraordinary abilities can innovate and create opportunities through their imagination and bold action. the pioneer will make another innovation. the fundamental difficulty in this theory is in measuring increasing or decreasing the units of factors can assess the marginal productivity. It does not recognize the risk-taking functions of the entrepreneur. In entrepreneurial function. To assume that all entrepreneurs are alike is highly unrealistic. 134 . An invention becomes an innovation only when it is applied to industrial progress. if it is not used.5. Now innovations bear the element of uncertainty and risks. But. if it is stillborn. profits will also be high. etc. So. Monopoly profits are permanent in nature while Schumpeter attributes the quality of temporaries to profits. According to Prof.” Innovation is brought about mainly for reducing the cost of production and it is a cost reducing agent. Thus theories of profits have become highly controversial and least satisfactory. Thus profit will appear and disappear and again reappear.be a change in the quality of the raw material. according to Schumpeter. profits are of temporary nature. 5. Invention is not innovation. Profit is the reward for this strategic role.2. gets abnormal profits for a short period. “Innovation is much more than invention. Chapman. Marginal Productivity Theory of Profit The theory of marginal productivity is also applied in the case of profit. it is not possible. Innovations are not possible by all entrepreneurs. better method of salesmanship. profits are equal to the marginal worth of the entrepreneur and are determined by the marginal productivity of the entrepreneur. The pioneer. that is. as a firm will have only one entrepreneur. a new form of energy. The theory is criticized on the following grounds: • • • Innovation is only one of the many functions of the entrepreneur and not the only function. Soon other entrepreneurs swarm in clusters and compete for profit in the same manner. who innovates.

There is wide variety of generally accepted accounting principles. remains the crux of the problem’.” However. these assets become useless from the point of view of business and they have only scrap value. According to Briggs and Jordan. “It is difficult to frame a simple theory of profits which would include the small independent trader. some differences arise due to the definition of profits by accountants and economists and also due to financial accounting conventions.3. Hence. uncertainty and innovations are factors of vital importance. In course of time. knowledge of these theories helps businessmen in formulation of their profit policies. valuation of assets. Even in the accounting sense. measurement of profit is not an easy task. is not so simple as it may appear. Some of them arise out of conceptual differences with reference to costs. 5. Measurement of Profit The measurement of the amount of profit earned by a business firm during a given period.3. they are in sense complementary theories. though none of these theories is a correct explanation of profits. the problem arises in the question ‘what is included in the costs to be subtracted from revenues to obtain profits. which provide for different methods of treatment for certain items of revenuer of expenditure. machines and building are used and they wear out over a period due to frequent use. Depreciation We know that in every business.Managerial economics. whilst excluding responsible managers. they are: • • • • Depreciation Valuation of Stock Treatment of deferred expenses Capital gains and losses 5. There is no single theory giving satisfactory explanation regarding profit. and the shareholder.1. In particular. The following methods are generally considered while measuring profits. In due course their 135 . The use-value of the assets of the firm goes on diminishing due to wear and tear. as they affect profit-earning capacity of the firm. equipment. makes little direct use of the theories of profits. though it makes use of the assumptions of profit maximization. the small holder. It is possible that monopoly. of a Joint-Stock Company. Several practical difficulties are involved here. the large employer. and legal requirements. income.

There are three commonly accepted methods of depreciation. banks. If the asset has an estimated scrap value its amount will have to be deducted from the initial cost before dividing it by the estimated life in years.1.3. transport. Straight Line Method: According to this method. Hence depreciation is provided on a uniform basis regardless of the fact that the asset depreciates more rapidly at some stages. Methods of measuring depreciation: There are a number of methods of measuring depreciation for the purpose of reporting business profits to the shareholders and taxable profit to the income-tax authorities. It varies in importance from company to company. assuming that there is no scrap value. 136 . This is calculated by using this formula: Initial cost of the asset Depreciation = Estimated life span of the asset in years The amount of annual depreciation is obtained by dividing the initial cost of the asset by the estimated life in years. In the case of heavy industries like iron and steel. they are: • • • Straight Line Method Declining Balance Method Sum of the years digits method We shall discuss these methods of measuring depreciation in a greater detail.1. accountants make periodic charges to income to recover the cost of equipment before its usefulness is exhausted. In the case of firms like insurance companies. Depreciation is an important internal source of funds and hence the method of depreciation becomes very significant as a tool of capital formation.value from the viewpoint of business declines. the depreciation charges will be relatively lower. This charge is known as depreciation which represents the decrease in the value of the assets due to use during a particular period. etc. an asset is supposed to wear out evenly during its normal life. wholesale business and retail business.. to measure true income of the business. 5. Therefore. say a year. very heavy depreciation charges are provided. financial institutions.. etc. This provision for depreciation charges will not be uniform in all firms. railways.

Hence. the life span of the asset is expressed in terms of working hours. 2000 = Rs.4500 which would be Rs. the depreciation for the first year would be Rs. Declining Balance Method Under this method. If the cost of the asset is Rs.10. depreciation is calculated by dividing the initial cost less scrap value by the number of working hours. This method does not take into account the increasing cost of repairs in the later years of the life of the asset and as a result.900 10 Under the working hours method. Rs.3. obsolescence or inadequate capacity.Rs. the asset is assumed to have some scrap value.450 = 4050.500 = 4500 and the depreciation for the second year would be calculated at 10% for Rs. The annual depreciation charge on the asset will be: Rs. i.1. In those cases.500. When there are no possibilities of premature retirement of assets due to accidents. 2 Per working hour 1000 The straight-line method is very simple in adoption. Suppose that an asset has a working life of 10000 hours and its original cost is Rs. Rs. The depreciation per working hour will be calculated as follows: Rs. The formula for determining the fixed rate of depreciation under ‘Declining Balance Method’ is as follows: D =100 {1-n√s/c} Where. 22000 – Rs. in this case the written-down value of the asset for the next year would be Rs5000.5000 and the rate of depreciation is 10%.405 in the third year.e. 5. the written down value however small.2. During the third year the depreciation would be 10% of Rs.10000 with a scrap value of Rs. and Rs.4050. the depreciation amount will show a declining trend..1000 = Rs.Illustration: suppose that an asset has an original value of Rs.1000 and its life span is estimated to be 10yrs.4500 – Rs.22000 and its scrap value is Rs 2000. 137 . rather than in years. 000 – Rs. the total cost of operation is likely to be disproportionate in the later years.500 in the first year. Rs.450 in the second year.405. will never be zero. Under this method. Thus. depreciation is provided on a uniform rate on the written down value of the asset at the beginning of the year.

3.D = % of depreciation s = Scrap or residual value of the asset c = Initial cost of the asset n = Estimated life of the asset in the years.12000 and its scrap value is Rs.. which is double the reciprocal of the estimated life: Uniform rate or d = 2 (1/n) The basic idea behind this method is to provide for a more or less uniform total cost of operation of the asset over different years of its life. to provide for a uniform total cost of operation of the asset. is equated over different years.1. The method of computing the fixed rate of depreciation as described above is rather complicated. i. but it declines progressively in the later years. A similar and more widely used method is to use a uniform %.2000 and its expected life is 4 years. under this method.e. depreciation is higher in earlier part of the asset’s life. In the beginning.3. Thus the depreciation rate is composed of a varying numerator and an unvarying denominator. On the other hand. the asset has an expected life of 138 . The Sum of the Year’s Digits Method: The basic idea of this method is similar to that of the Declining Balance Method. The combined effect is that the total charge in the profit and loss account so far as the asset is concerned. This method differs from the declining balance method in that the base or book value remains constant while the annual rate of depreciation changes. The amount of depreciation in the beginning of the life of the asset is higher and it progressively declines with the passage of time. 5. The numerator of the fraction for each year is the expected life of the asset in that particular year and this declines by one each year. The variable rate of depreciation is calculated as follows: • • Each digit of the years of the useful life of the asset is added up and the resulting figure is the denominator of the fraction to find out the depreciation rate. And this rate is applied each year to the asset’s original cost. Illustration: The sum of the Year’s digit method can be explained with the following illustration: Suppose the original cost of the asset is Rs.

But in other years. one year later it has an expected life of 3 years and so on. 12000 and the scrap value is assumed to be Rs. 4000 7000 9000 10000 Book value of the asset Rs. the charge for depreciation is higher towards the end. The original value of the asset is Rs. 8000 5000 3000 2000 The Declining Balance Method and the Sum of the Year’s Digit method are useful. which will be the common denominator of the annual rates. Under the Declining Balance Method.2 and 1 years.4 years. In the first year. Thus the annual rates are 4/10. the rate of depreciation is 2/10 or 20% or Rs2000 and in the fourth year. the profits are affected equally throughout. From this. Thus the expected life periods of the asset are 4. Depreciation and Profit: We studied three methods of calculating depreciation of an asset. TABLE –5. both these methods are called Accelerated Depreciation Methods. As a result. Under the Straight Line Method. 10000. 3/10. the annual depreciation charge should be made for Rs.4000.2000. The numerators are respectively 4.3000.1 The Annual Depreciation Age of the asset in years 1 2 3 4 Rate of depreciation 4/10 or 40% 3/10 or 30% 2/10 or 20% 1/10 or 10% Annual depreciation Rs 4000 3000 2000 1000 Accumulated depreciation Rs. The sum of these expected life periods is 10.2 and 1.3.3. in the second year the rate of depreciation is 3/10 or 30% or Rs. the rate of depreciation is 4/10 which is 40% and the depreciation amount is Rs. As between the two methods. and the Sum of the Year’s Digits Method. the depreciation is higher under the Sum of the Year’s digits method. we can understand that the amount of profit of a firm depends on the method of depreciation 139 . In view of the fact that depreciation is higher in the initial years. where the cost of repairs increase as depreciation charges decrease. the rate of depreciation is 1/10 or 10% which is equal to Rs. in the third year. the charge is higher in the firs year in the case of Declining Balance Method than under the Sum of the Year’s Digits Method. the charge of depreciation is the same throughout the life of the asset. as well as equitable in calculating depreciation. These data can be tabulated as shown in the table. 2/10 and 1/10 respectively.1000.

a company can choose any 140 . there is an adjustment in the capacity to pay taxes and the tax liability is adjusted with the capacity to pay. With the same machine. since the accelerated methods result only in postponement of tax rather than its permanent avoidance. under the accelerated depreciation methods. and these tax rules impose constraints on the managerial choice about depreciation method. different firms can show different amounts of depreciation and consequently. For the young and growing firm. building. the capacity to pay tax is also lower. the ‘Accelerated Depreciation method’ offers advantages as the new companies will have limited capital and they may need funds for expansion. accelerated methods of depreciation are more effective than the straight-line method. this method is better suited than the ‘Straight-Line Method’ if the companies are engaged in the programme of capital expansion and replacement of assets. Even for well-established companies with excellent credit facilities. different amounts of profit. In the U. However. • Under the accelerated depreciation method. etc. Consequently. the tax liability is lower in the beginning and higher towards the end. it is desirable to write-off the asset as soon as possible in this respect. the tax liability being lower in the earlier years of the life of the asset.. The advantages are as follows: • Taxable income and income-tax liability would be substantially larger towards later years only under the declining balance method and the sum of year’s digit method. amount to an interest-free loan from the Government to the company. there are certain restrictions about the adoption of depreciation methods by the tax rules of different countries. • In the case of assets subject to rapid obsolescence. • The capacity of a firm to earn profits from the use of an asset is lower in the earlier part of the life of the asset. These funds. plant. in effect. the company has the benefit of retaining a part of the funds which would have been payable as tax under the straight-line method.A. equipment. Thus.S.adopted.

• FIFO Method (First In First Out): According to this method.2. the inventory is supposed to consist of goods purchased most recently. weighted by the quantity purchase at that accost. the depreciation is 10%. and stock acquired very recently will be issued only later. there are prescribed rates of depreciation to be applied to the written down value of the asset under the declining balance method. • Weighted Average Method: This method assumes that it is not possible to identify separately the materials purchased at different times at different prices. Holland and Sweden have introduced ‘Accelerated Depreciation Method’ with the object of stimulating investment. i. restaurants. The closing stock is valued at the average cost. In the case of building it is 2.5%. France. In Australia. In India.e. cinema theaters.. at the beginning. Under this method. As a result. 5. it is assumed that the units of stock acquired first should be issued first. 141 . In the case of furniture and fittings. Consequently the cost of one unit cannot be distinguished from the cost of another. • LIFO (Last In First Out) Method: According to this method. Units are issued at a cost of which is an average of the cost of each purchase. it is assumed that the units acquired last are the units to be issued first. With rising prices. the purchase cost would have been lesser and later it would have been larger. the Straight-Line or the Declining Balance Method may be used. Valuation of Stock In business.one of the three methods we studied above and the Internal Revenue Act permits this. The significance behind this is that the company may not have acquired the stock at the uniform price throughout. For general machinery and plant. the valuation of stock will influence the profit and the method adopted in arriving at the valuation of the stock would have decisive impact on the profit. There are three methods viz. the inventory is supposed to consist of materials purchased earliest. etc. Other countries such as Denmark.3. First in stock should go out first. the depreciation is 15% when used in hotels.

the value of the stock on hand after issue to the Production Department will be Rs. the first acquired should go out first.50 and the stock will be valued at Rs. are valued at Rs. Under weighted average method.50 on the basis of above purchase price and quantity.50.50.912. the valuation of stock is higher under FIFO method and lesser under LIFO method in this particular case. Hence.912. of the chemical to the production department. Under this method.912. We know that the total procurement cost under LIFO method is Rs.50 per kg. Under LIFO Method.0 under FIFO method. the materials issued will be valued at Rs.850 under LIFO method.50.881.25 and the subsequent 150kgs.3.881. the quantity issued to the production department will be valued at Rs. so.25.850.850 after issue. How will the stock on hand be valued under different methods? Under FIFO method.25 and the stock will also be valued at Rs. 3. the materials department issued a quantity of 250kgs. Valuation of Stock and Profit: The impact of the method used in determining the value of the stock depends on the movement of prices of the commodity in question.and the stock on hand with the materials department will be valued at Rs. 142 .75 per Kg Suppose that on April 10. 3. According to this method. Thus.912. At Rs. Thus. This will work out to Rs. the first 150kgs should be valued at Rs.1762.3. are valued at Rs. we can see that the stock on hand after issue is valued at Rs.50 per Kg : 150Kgs.850. The total value of 250kgs comes to Rs. the materials issued will be valued at Rs. it will be seen tat the value of the stock is different under different methods. which is the purchase price. In other words.25 per Kg : 250Kgs. At Rs. 3. Generally. the stock on hand comes to Rs.3. Hence the first 100kgs.50.50. of a particular chemical at different times and at different prices as stated below: Purchased on February 18th Purchased on March 20th Purchased on March 31st : 100Kgs. Hence.912.850/. Suppose a firm purchases for its factory production 500 Kgs. At Rs.912. the total value of the stock before issue comes to Rs. and the stock on hand after issue is valued at Rs.Illustration: Let us take a hypothetical case to illustrate the three methods mentioned above in the valuation of stock. recently procured materials should be issued first (Last In First Out).

The stock is values at the earlier cost. In period of deflation. • Those having a limited life. But.000 dollars in income tax. i. Treatment of Deferred Expenses – Allocation of expenses over Time Periods The firm will have intangible fixed assets and the problems come in writing off these intangible assets during their lifetime. The Average method lies somewhere in between LIFO and FIFO methods. It is stated that an American manufacturer saved nearly 19. 5. or almost nil. i. be higher.500. Section 145 provides that profits shall be computed in accordance with the method of accounting regularly employed by the assessed. etc. Joel Dean has recommended the adoption of LIFO method and the accounting bodies of UK have also recommended the same. Intangible fixed assets can be classified into two categories. Copyright.e.. therefore. the income-tax authorities would insist on using only one particular method and it should be adhered to consistently and a departure from the method will not be allowed. and 143 . the profits are determined accordingly.in an inflationary period. This also will lead to higher profits. the resultant profit will. The Income Tax Act does not lay down any specific method about the valuation of stock. it tends to reduce income-tax liability. As LIFO method tends to show lower profits in an inflationary period. permits.3.. e. The reason is that during the period of inflation.3.. So. But. Leasehold. rising prices due to inflation have become the general trend and deflation is a remote possibility. the LIFO method or Average method.e.. the costs are high and since most recent costs are taken into consideration under LIFO method. Our experience after the Second World War shows that in out economy. Prof. later costs. A method regularly employed will include the method of valuation of stock also and it cannot be changed to suit the convenience of the assessee.g. The inventory will be valued at the higher costs. these lower costs would be debited to the Profit and Loss Account. the businessmen find it expedient to adopt LIFO method in the valuation of stock. under lower cost. over a period of 19 years by adoption of the LIFO method. Under FIFO method. In times of deflation the FIFO method is more beneficial. LIFO method will tend to produce higher income than FIFO method or Average method.

5.4. Intangible assets with no limited life pose more complicated problems for two reasons: • • There is a difference of opinion whether the assets should be written off at all or not If they have to be written off. It is. To illustrate this point. On the other hand. what should be the period for their amortization? This amortization can be done either gradually or by an immediate write off. But publications may not have an active market for such a long period. a rational view would be to write off the good will over an appropriate period of time. Conservative companies may decide not to include capital gains in the current profit. The conservative view is that the good will is only a fancy asset having no place in the balance sheet.. Good-Will of the business. Thus the amount of profit would be affected by the treatment of capital gains and losses. etc. Hence. windfall reflects a change in someone’s anticipation of the property’s earning power. or “Windfalls” may be defined as “unanticipated changes in the value of property relative to other real goods. Businessmen prefer to write off the intangible assets having limited life before their useful life expires. to eliminate these intangible assets as soon as possible. the company may decide to write it off out of retained earnings. This is based on conservatism. considered advisable to write off the cost of copyright against the income from the first edition. copyrights have life equal to author’s life plus 50 years thereafter. But this view cannot be fully endorsed.e. a company may decide to include the capital gains in the profits of the year. good will may ensure certain decisive advantages to the firm. Legally. therefore. as in some cases. Regarding capital losses. That is. e. Trade Marks. At the same time. i. they would like to write off capital losses from the current profits of the year in which the loss occurs. The example of this type is provided in the case of ‘Copyrights’. 144 .3. “Good-Will” can be taken for discussion. Preliminary Expenses.• Those having no such limited life. Fluctuations in stock market prices are all almost of this nature”.g. Capital Gains and Losses Capital gains and losses.

• The pattern and quantum of demand is uncertain. the firm adopts the new technology. • In a period of continuous rising prices. consumer preferences of commodities are highly subjective and the firm may not be able to predict the demand precisely and firm faces this uncertainty.In the case of unrealized capital gains. the nature of competitions. as well as taxes to be paid. All these show that there can be discrepancies in the profit reported by different companies because of the different approaches that they adhere to the treatment of capital gains and losses. Barring the basic requirements of life and other essential commodities. These uncertainties may arise due to the dynamic nature of the consumer needs. 145 . The profits cannot be left to chances and it has to be planned. continuous change in technological developments and uncontrollable nature of cost of production. This is a risk and the firm has to take steps to forecast the demand for its products. This is another uncertainty. the gain resulting out of it is usually transferred to capital reserve. Product competition is more important till it reaches the stage of maturity. no firm can be certain of its own cost structure. The competition may be price-competition or product competition or it may be both.4. Profit Planning A firm has to face many uncertainties and risks. there is unanimity that they should not be included in the profits. as it cannot have control over the price of raw materials and wages and transport cost. The symptoms of a healthy business include making a reasonable profit consistent with the risks it has to face. • The firm has to face competition from the rival producers. • Improvements and change in technological developments may make a firm’s product obsolete and push the firm out of business. A firm faces unpredictable demand for its products. viz. If there is a revaluation of property. unless. 5..

Accountants. on the other hand. Expansion of output beyond OQ1 results in decline in profits due to diminishing returns and diminishing marginal revenue . Unless the firm takes an extra ordinary care to study all the above factors prone to risks. The firm has to plan for the profits by having a thorough knowledge of the relationship of cost. 5. The Break-even analysis helps in understanding the relationship between the revenues and costs in relation to its volume of sales. assume that variable cost varies in direct proportion to output and the break-even point is constructed assuming linear cost and revenue functions. Break Even Analysis A business unit breaks even with its total sales value if it is equal to its total cost.VOLUME PROFIT ANALYSIS and takes decisions accordingly to decide the quantum of profit.. Economists assume that revenue and cost vary over increasing volume of output. the profits would be left to chance. Break–even point (BEP). The figure 5.2 shows the Accountants view point.analysis. If a firm does this exercise elegantly and efficiently. cost price and volume will have a definite bearing on the profit making ability of the firm. If a firm makes thorough study and exercise of COST. price and volume in the enterprise . viz. then the firm is said to have adopted ‘Profit Planning’ effectively. The comparison of the two views is given in the figure by depicting the structure of the break-even chart according to Economist and Accountants. the targeted profit can be ensured.5.The Total Revenue Curve 146 .All these create a condition of risk and uncertainties for the firm to survive in the business and to make profit in the enterprise. 5. refers to that level of sales volume at which there is neither profit nor loss. In the Economists figure the firm should produce OQ1 to maximize profits. The most important method of determining the cost-volume-profit relationship is that of Break.even.1 indicates the Economist’s viewpoint of break-even and the figure 5. It helps in determining the volume in which the firm’s cost and revenue are equal.The knowledge of manipulation of these.5.1 Differing Views on Break-Even Point Accountants and Economists differ on break-even point. costs being equal to its sales value and the contribution is equal to fixed expenses.

higher is the profits.1: The Break-even Chart According to Economist Figure 5.2.The Total Cost Curve simultaneously continues to increase since extra output does not have a zero cost . Break even point is at B where TC=TR .The figure shows the level of output where profits are the maximum.eventually drops down. Figure 5.2: The Break-even Chart According to Accountants In the figure 5. as greater quantities can be sold only by lowering the prices . TR will be always at a higher 147 . This view suggests that higher the output. This situation corresponds to the distance between TR and TC. the BEP is constructed assuming linear cost and revenue functions.In the Accountants figure.

00.1.50 = Rs.42.00.1 lakh.000 Selling price = Variable cost + Fixed Cost per unit = Rs.Variable cost per unit (a) Illustration: Find out the BEP from the following data: Variable cost per unit =Rs 30/Selling price per unit =Rs 40/Fixed expenses Answer: Rs.12.40-Rs.000 = 8.50 = 12.000 Total fixed cost Fixed cost per unit = Number of units 1. as these are assumed to be linear .TC in this figure will never drop down. 00.5. calculate the selling price per unit if BEP is brought down to 8.000 BEP = Rs.000 = 10 For this illustration.2.30 + Rs.30 1.AVC = Total fixed expenses Selling price per unit .level beyond BEP showing increasing profits with the increase of output . 148 .000 Units = Rs.The Economist figure is realistic and the Accountants figure is practical 5.50 = 10. Calculations of Break-even Point The following formula could be used to find out the Break-even point Total Fixed Cost BEP = Selling price.

000 x 5 = 2 Break. It helps the business firm in • • • • • Calculating output or sales to earn a desired profit.even analysis helps the business firm in focusing on some important economic leverage. Margin of safety Change in price Make decisions. we have to calculate the contribution ratio and then we have to calculate the BEP: Total revenue minus Total variable cost Contribution ratio = Total revenue Sales minus variable cost = Sales = 10.6. = Rs.000 In this case.3.Break-even point in terms of sales value (b) Illustration: Find out the BEP in terms of sales value on the basis of following data: Sales =Rs.000 10.10.000 Total fixed cost BEP= Contribution Ratio 3.000 Fixed cost = Rs.000 Variable cost =Rs. and Change in cost and price etc. 7500 = 2 5 149 . which could be operated suitably to enhance its profitability.000-6.000 2/5 3.

4 per unit.12.5.000 .00.30lakhs. 5.00. we get: 20.5.Variable cost Rs. and selling price Rs.000 with the following data: fixed cost Rs.30. Calculation in Terms of Target Profit (c) Illustration: Find out the target sales volume.20. A reduction of price will result in the reduction of contribution * 100 *100 150 .000+12. if the desired profit is Rs. the firm will be faced with problems of taking decisions for reducing the price or not.000 unites 5.4.000 Safety margin = 40.000 = 25%of present sales.5.00. 8 per unit. 000.3. According to Break even Analysis the formula for Fixed cost + Target profit Target Sales volume = Contribution margin per unit Substituting the values to the formula. find out percentage of margin of safety? The formula for Safety margin is as follow: (Sales-BEP) Safety margin= Sales 40.000 Target sales volume= 8-4 32.000 = 4 Target sales volume = 8. Calculation in Terms of Safety Margin (d) Illustration: If the present sales of a firm is Rs.40 lakhs and Break-even sales are Rs.5. Calculation in Terms of Change in Price and New Sales Volume: Very frequently.5.

24 per unit there is a proposal to reduce the price of the commodity by 20 per cent.000 Rs. should be manufactured by them or brought from out side firms.000+5. the management has to take decision regarding the increase of volume of output in order to maintain the same profit level in the context of reduction in price.54. Reduction in price need not necessarily result in the increased sales.8.000 units at Rs. Price reduction of 20% is justified if the management is confident of raising the sales to 8000 units.000 units.000 = 10. 24 Contribution Less fixed expenses Present Profit =1. How many units should the firm sell to maintain the present level of profit? Sales value of 4. Rs. If he decides to = 64. The formula for determining the new volume of sales with given reduction in price will be as follows: Total Fixed cost + Total profit New sales volume = New selling price.margin.000/8 = 8.000 unites per month at a price of Rs.40 Less variable cost of 4.32.4000 New sales volume = 32-24 The firm has to increase the sales from 400 units to 8000 units. Break-even analysis also helps to decide whether components.10.Average variable cost (e) Illustration: A firm sells 4.000 units at Rs.40 Reduction of price is 20 per cent. 000 at new price of Rs. which are part of their finished products. 54. i.60.000 Old price is Rs. Assuming that it remains constant.000 = 96..10. Fixed cost works out to Rs. as it depends on the elasticity of demand of the commodity produced by the firm. hence. the new sales price is Rs.000 = 64.e.000 per month and variable cost comes to Rs.40per unit. Illustration: A manufacturer of bicycles buys a certain part at Rs.32 per unit are: Rs.40 each. 151 . Sales needed to maintain the present profit of Rs.

labour etc. material. this technique was used in planning the diversified operation of US Air-Force. Quadratic Programming. if he needs more than 2000 components per year. Variable cost Rs. To put it in a simpler way. money. i. so as 48000/24 = 2000 152 . resources. his cost would be as follows: Fixed costs Rs 48000.6. 5. A producer has to take decisions to make use of the little resources in order to get maximum output. Leontief developed this for input-output analysis.16 per unit. Thus the Break-Even analysis is useful to the management in determining profit policies and profit planning.e. space. and Non-Linear Programming. 5.C Break-Even Point = Purchase price. If his requirement is less than 2000 units. Dorfman and Samuelson have made significant contributions. Integer Programming. F.16 This shows that the manufacturer can produce the parts profitably.. We have linear programming. Dentzig in 1947. We know that resources are very limited and there are constraints in getting adequate resources and also in the process of production.Variable cost 48000 = 40.. Originally. However. The present version is the work of mathematician George B. The problem before the management is the allocation of firm’s resources. Economists like Koopmans. viz.6.manufacture it himself. The origin of linear programming dates back to 1920s when W. or to make a unit output with minimum cost. Linear Programming There are many varieties of analytical techniques to solve constrained optimization problem.1 Meaning of Linear Programming Linear programming is a mathematical technique by which rational decisions are taken in production to optimize output with the constraints of limited input. it is better to buy from outside firms. time. Cooper. linear programming technique has been developed more and used frequently. it is useful in allocating the limited resources in an optimal manner in production. Find out if it is profitable for him to manufacture the parts instead of buying.

Moreover. it is a problem of not only optimization. the given limitations may state only the maximum amounts of the inputs that are available or it may be only certain 153 . connotes.2 Need for Linear Programming Technique In economics. Hence. the constraints may be precise or specific.to get maximum profit. Linear Programming is defined as “a mathematical technique of study where in we consider the maximization (or minimization) of a linear expression (called the objective function) subject to a number of a linear equalities and inequalities (called linear restraints)”. where the problem is to obtain an optimum solution with constraints. then. we have studied about Marginal Analysis and Least Cost Combination Techniques.6. this is an important tool in decision-making and it is comparatively a new tool in decisionmaking. and at the same time. For instance. where is the need for the linear programming technique? Marginal analysis and calculus and other usual methods cannot be used in a situation. it should maximize National Income. The linear programming technique helps in realizing the objective of optimal utilization of resources for getting maximum returns or profits. rather than with the efficiency with which the resources are to be employed. instead they may impose only upper or lower limits on the decision-maker. that we are required to choose amongst a host of possible combinations of different outputs. 5. in the production analysis. This. if it is a problem of suitable choice of combination of outputs so as to maximize National income. with the constraints that no more than a given amount of resources should be used. For example. The usual methods are useful only in the context of resource allocation to achieve a particular goal. Realizing a particular objective in production is different from utilizing the resources most efficiently subject to certain constraints. etc. that combination which does not violet the given constraint conditions. The term ‘linear’ denotes that it is mathematically involving linear function. When we have these methods. This means that we can use only a given amount of resources and that the output level of each product has to be nonnegative. and the word ‘programming’ denotes mathematical procedures to get the best solution to a problem utilizing limited resources.

the production function must be linear. we mean that a 20% change in the productivity hours of work will lead to 20% change in raw materials and 20% change in output. such a situation can be obtained only under perfect competition.6. the number of hours of work and the units of products are proportional. Such constraints can be expressed only as inequality relationships. 154 . Some of the important assumptions are discussed below: • Assumption of Linearity: The main assumption in the technique is the linear relationship of the variable used in it. 5. These problems cannot be solved by means of marginal analysis. So. i.3 Assumptions of Linear Programming Technique The linear programming technique is based on certain assumptions in the process of obtaining the optimal solution. homogeneous production function of first degree.. revenue function and their composite. Thus the technique assumes linearity relationships. output and prices have to rise linearly. This further leads to the assumption of constancy of factor prices remain constant. We have to necessarily depend on a new technique of analysis. the raw materials used. i. i. This means a proportional relationship.minimum requirements that must be met.. which has been provided by linear programming.4. linear.e. Similarly..e. i.e.. which leads to the assumption of • • • • Constancy of product prices Constant returns to Scale Constancy of factor prices Perfect competition 5.6. The various relationships should be expressed in the form of equations or inequalities and they must be linear. For example. Characteristic Features of Linear Programming Problems All problems where linear programming is applicable have the following characteristic features. This assumption of linearity implies the constancy of product prices. By assuming linearity.e. i. the basic relationship between cost functions. the entire analysis rests on a condition of perfect competition. necessarily there must be constant returns to scale. If costs..e. profit function are directly proportional. the exponents of all variable must be one.

Let the profit per unit in case of these commodities be PR. • Non-Negativity condition: Linear Programming technique is a mathematical tool for solving constrained optimization problems. For example. the warehousing capacity and the amount of raw material available. S. The quantities produced are QR. like negative quantity. PS. S. the objective may be maximization of national income as the sum of outputs of different products. a requirement that any solution shall not lower the quality of the product is not a constraint in the linear programming sense. Some answers may be even negative and as such absurd. The objective sought after is known as the ‘objective function’. QS. The objective function would then be stated as follows: QRPR + QSPS + QTPT = Maximum • Constraints: This is an algebraic statement of the limits of a resource or input. For example. and T. If it is planning at the national level. PT respectively. the objective will be maximization of profit or minimization of cost. The producer wants to maximize profit ‘P’ for them.• The Objective Function: This clearly defines the objective of the programme in quantitative terms. Generally. in distribution problems. then it has to take account of the fact that they are limited by number of machines it has. in business. For example. Hence we would get any answer with any algebraic sign attached with it. R. QT respectively. suppose the commodities R. etc. When we get such a negative solution. This expression is usually in the form of inequalities.Y and Z hours of machine time and only ‘H’ hours of machine time is available. each require per unit of product X. which state the things that are possible or not possible to be done. If a firm is trying to maximize profits. it will be a practical impossibility. the optimal solution arrived at by the technique may be ‘negative shipments’ from 155 . S and T. then will be as follows: XQR + YQS + ZQT ≤ h The constraints like and objective function must be capable of arithmetical or algebraic expression. This tells about the determinants of the quantity optimized. as this cannot be expressed numerically. suppose a manufacturer produces three commodities. The constraints on the production of R. and T.

if the firm makes three products. R.one place to another. In our example. we would be required to include conditions that any factor-input or the quantity produced cannot be negative. it is necessary to include the non-negativity conditions. The first one is called the ‘graphical method’ and the second one is known as ‘simplex method’.e. in the illustration. There would be no negative production. Further. The latter requires advanced mathematical techniques involving extensive use of algebraic equations and manipulations.6. the computational procedure is very wearisome. it will be difficult to cope with the volume of data and calculations to find solutions to actual business problems. There are only 24 and 16 hours available on machine ‘a’ and ‘b’ 156 . or greater than zero. and without electronic computer. the non-negativity conditions would be: QR ≥ 0 QS ≥ 0 QT ≥ 0 • Linear relationship: As has been indicated already. Graphical method Problem: Suppose the objective of a firm is to maximize profit in the production of product ‘R’ and/or product ‘S’.5. the various relationships to be expressed in the form of equations or inequalities must be linear. So. proportional relationship.. Thus in any production problem. this is an impossible solution. 5. Both these products require two machines. Of course. S and T. But the Graphical Method is a simpler one having a close resemblance to indifference curve analysis. Methods of Linear Programming A problem related to linear programming can be solved by two methods. Thus. i. while product ‘S’ requires 6 hours on machine ‘a’. 5.6. namely. which means that the commodity is ‘reproduced’ or ‘dismantled’ which is absurd. In order to eliminate such impossible and non-sensual results. machine ‘a’ and machine ‘b’ for purposes of processing. This method can be used very elegantly where there are a few decision variables.6. but only 2 hours on machine ‘b’. Product ‘R’ requires 4 hours on both the machines ‘a’ and ‘b’. the quantity of production should be either zero or positive. the non-negativity condition merely states the fact that all variable in the problems must be equal to.

R ≥ 0. It may be less or equal to the time available on the machine.14S If P = Profit.and Rs. S ≥ 0. we have dependent variable. the first inequality states that the hours required to produce one unit of ‘R’ (4 hours) multiplied by the number of units of ‘R’ produced plus the hours required to produce one unit of ‘S’ (6 hours) multiplied by the number of units of ‘S’ produced must be equal to or less than 24hours available on machine ‘a’. We have the objective function.12/. This is an equation showing relationship between output and profit.. 12R + Rs. profit which is to be maximized and this is the function of two independent variables ‘R’ and ‘S’ the production of which is restricted by the time available in the machines.e. to get meaningful answers.. i. viz. P = Rs.14/. First Step: (Formulation of problem) The above stated information has to be formulated in mathematical form. These are the constraints and the constraints can be expressed mathematically as follows: A: B: 4R + 6S ≤ 24 4R + 2S ≤ 16 This means. A similar explanation holds good for the second inequality. Now. Both these inequalities represent capacity restrictions on output and hence on profit. The profit per unit is estimated at Rs. Finally.respectively. To sum up we get: Maximize subjects to constraints P = 12R + 14S 157 . the values of R and S must be positive i. Rs. Thus solutions for R and S must be either zero or greater than zero.12R = Total profit from sale of product ‘R’ Rs.14S = Total profit from sale of product ‘S’ The time taken in processing the products in the machines must not exceed the total time available on each. producing negative quantities of R and S may not convey any meaning.e.in the case of ‘R’ and ‘S’ respectively.

4R + 6S ≤ 24 4R + 2S ≤ 16 R ≥ 0; S ≥ 0. Second Step :(Plot the constraints on Graph) The next step is to plot the restraints of the linear programming problem on a graph paper; products ‘R’ to be shown on ‘X’ axis and product ‘S’ on ‘Y’ axis (Figure 5.3). The inequality 4R + 6S ≤ 24 may be drawn on the graph first locating its two terminal points, and then joining these two points by a straight line. This is done in the following manner. If we assume that all the time available on machine ‘a’ is used for making product ‘R’, then it would mean that the production of product ‘S’ is zero. Then 6 units of product ‘R’ would be made. Thus, if S = 0, then R ≤ 6. If we produce the maximum number of product ‘R’, then R = 6. so the first point is (6,0) to be plotted in the graph, i.e., zero product of S and 6 units of R. In order to find the second point, we assume that all the time available on machine ‘a’ is used in making ‘S’; i.e.., production of ‘R’ is zero. Under this assumption, we get 4 units of ‘S’. Thus, if ‘R’ is zero, then S = 14. The maximum number of ‘S’ would be 4. So, the second point is (0,4). This denotes 4 units of ‘S’ and zero unit of ‘R’. Locating these points, viz., (0,4) and joining them, we get a straight line AB as shown in figure –5.1. This line shows the maximum quantities of product R and S that can be produced on machine ‘a’. The area AOB is the graphic representation of inequality 4R + 6S ≤ 24 It can be drawn graphically as shown in the figure. Similarly if the output of ‘S’ is zero, the maximum output of ‘R’ on machine ‘b’ will be 4, i.e., (4,0). If the output of ‘R’ is zero, the maximum output of ‘S’ on the machine ‘b’ will be 8. i.e., (0,8). Locating these two points and joining them, we get straight line CD, as shown in the figure. This line again represents the maximum quantities of products R and S that can be produced on machine ‘b’. The area COD the graphic representation of inequality 4R + 2S≤ 16

Figure 5.3 Graphical Representation of Linear programming Problem

158

Third Step: Finding out Feasibility Region and Co-ordinates of its Corner Points. The third step is to identify the cross-shaded portion are OAED in the figure. This is generally known as feasibility region. This is formed with the following boundaries; X axis; Y-axis; AED boundary is formed by the intersection of lines AB and CD at point ‘E’. If a point is to satisfy both the constraints and the non-negativity conditions, it must fall inside the cross-shaded area or on its boundaries. All points outside the feasibility region are inadmissible. For example, if we begin at the origin O, we cannot travel beyond point ‘D’. If we were to proceed further, the capacity restriction of machine ‘b’ will be violated. Similarly on the Y-axis, we cannot proceed beyond ‘A’. Moving beyond ‘O’ leftward or downward would not satisfy non-negativity conditions In this feasibility region, we have to study the corner points, as the optimum solution invariably must lie in one of the corner points. We know the co-ordinates of three corner points, viz., Corner point O A D R (0, (0, (4, S 0) 4) 0)

159

The co-ordinates of point ‘E’ however, are yet to be ascertained. One method is to read the co-ordinates in the figure itself, if it is drawn accurately and to the scale in the graph sheet. Another method is to solve simultaneously the equations of the two lines, which intersects to form point ‘E’. The equations to be solved are: 4R + 6S = 24 4R + 2S = 16 Solving these two equations we get the value of R or S 4R + 6S = 24 4R + 2S = 16 - 4S = 8 S=2 Now, substitute the value of S in the equation 4R + 6S = 24. We get value of R = 3. So, the co-ordinates of point ‘E’ are (R=3: S=2) Fourth Step: Find Most Profitable Corner Point The final step is to test the four corner-points, viz., O, A, D; E. Of the feasible region OAED and to see which corner- point yields the maximum profit. Corner-point Corner-point Corner-point Corner-point O; A; D; E; (0,0) (0,4) (4,0) (3,2) = 12(0) = 12(0) = 12(4) = 12(3) + 14(0) + 14(4) + 14(0) + 14(2) = 0 = 56 = 48 = 64

The corner-point which yields the maximum profit is ‘E’ and the maximum profit is Rs.64/- Thus, the graphical method of linear programming consists of formulating the problem, plotting the capacity restraints on the graph; identifying the feasibility region and its corner-points and finally testing which corner point gives the maximum profit. 5.6.7. Simplex Method Another method of liner programming is the Simplex method. The simplex method offers a means of solving the more complicated programming problems. The simplex method, however, is more complex than simple’ and involves somewhat unsophisticated, complex mathematics. The complexity lies in the manipulation of numbers. The simplex method for solving linear programming problems was developed by G.B. Dentzig. 160

Successive solutions are developed in a system at pattern until the best solution is reached. On machine1.6.2. 3 per chair [X2].4X1+Rs. hence in working towards the optimum solution.1 Characteristic features Simplex method possesses two worth mentioning characteristic features. First. I Step: Develop Equations from the Inequalities (Adding SLACK Variables) The first step is to change the inequalities for the two constrains in our problem into equations.3X2 Subject to 2X1+X2 ≤ 30 hours X1+ 2X2≤ 24 hours Solving a problem by the simplex method requires (1) arranging the problem equations and inequalities in a special way and then (2) Following systematic procedures and rules in calculating a solution. Each table [X 1] needs 2 hours on machine 1 and 1 hour on machine 2. 30 hours are available and on machine 2. Stating mathematically. A slack variable represents costless process whose function is to ‘use up’ otherwise unemployed capacity. To iterate means to repeat. 24 hours are available. 4 per table [X1] and Rs. following a standard pattern. in the simplex method. The profit is Rs.7.5. In effect. each new solution will yield a profit as large as or larger than the previous solution.7. A manufacturer makes two products. We cannot use the simplex method unless all the inequalities are converted into equations by adding slack variables. The problem is to determine the best possible combination of tables and chairs to produce and sell in order to earn the maximum profit. Let us explain what a slack variable is. Each chair [X2] requires 1 hour on machine 1 and 2 hours on machine 2. the slack 161 .6. the computational routine is repeated over and over. which must be processed through two machines. tables and chairs. 5. Linear programming problem Let us take linear programming problem. This important characteristic assures us that we are always moving closer to the optimum solution. the computational routine is an iterative process. say machine time or warehouse capacity. the linear programming problem is: Maximize profit =Rs. Secondly.

S2 is equal to the total time available on machine 2 (i.. 30 hours) less any hours used there in processing tables and chairs. S2= Slack variable (unused time) on Machine 2.e. by adding the slack variable S1. the inequality 2X1+X2 ≤ 30 hours is changed into the equation 2X1+X2+S1=30 hours Likewise by adding the slack variable S2. S1 is equal to the total time available on machine 1(i. we can restate the equations for the slack variable S1and S2 as under: S1=30-2X1-X2…machine 1 S2=24-X1-2X2…. the inequality X1+2X2 ≤ 24 hours is changed into the equation X1+2X2+S2=24 hours In other words. Two examples will make this point clear. we process 3 tables (X1) and 2 chairs (X2).variable represents unused capacity and it will be Zero only if production facilities are fully used. we process 3 tables (X1) and 5 chairs (X2). the slack variable on each machine takes on whatever value is required to make the equation relationship hold. Example1. we could change the constraint inequalities in our problem into equations. Mathematically. Suppose that on machine 2. machine2 We may also see that by adding the slack variables. S2=24-1(3) -2(5) = 24-3-10=11 162 . Similarly. To take an example: Let S1=Slack variable (unused time) on Machine 1. The slack variable makes the right-hand side of an inequality and up the lefthand side. Thus..e. 24 hours) less any hours used there in processing tables and chairs. Suppose that on machine 1. S1=30 hours – 2(3)-1(2) 30-6-2=22 Example 2.

(1) Cj row: In the simplex tableau.3X2.We can now restate our linear programming problem in the from in which it will be used in the simplex method. also known as objective row. It may be pointed out that whereas S1 and S2 are the slack variables. S2 is added to the equation representing the time constraint on machine 1.2). in contrast. we insert the coefficients in the objective equation. it is added to the equation-representing machine 2 with Zero coefficient. For example.2): 163 . any unknown that appears in one equation must appear in all equations. are called structural or ordinary variables.3X2 +0S1+0S2 Subject to 2X1+X2+S1+0S2=30 hours X1+2X2+0S1+S2=24 hours II Step: Develop Initial Simplex Tableau We can now set out whole problem in what is known as a simplex tableau. It will be helpful here to describe the simplex tableau and to identify its various parts. since S1 represents unused time on machine 1 only. the first row is the Cj row. which yields no profit. X1 and X2. the slack variables must be non-negative.4X1+Rs. Thus. The simplex tableau is a table consisting of rows and columns of figures and is also known as simplex matrix. Furthermore. For the same reasons. The unknown that do not affect an equation are written with a Zero coefficient. since S1and S2 represents unused time. Further. Thus we get the following equation: Maximize Profit =Rs. In this row. In the simplex method.4X1+Rs. It is: Maximize Profit (P)=Rs. Subject to 2X1+X2+S1=30 hours X1+2X2+S2=24 hours The above form is referred to as the equality form of the programme the only changes we have made are the introduction of slack variable into the constrains. the Cj row appears as follows in the initial simplex Tableau (Table 5. these variables are added to the profit function with Zero coefficient. We illustrate below the form of simplex tableau or matrix and explain its various parts (Table 5.

.3 X2 Rs.2 –Parts of Initial simplex Tableau Cj Profit per unity Product mix column Constant column (i. Thus.e. we write that constant 30 in the first row and constant 24 in the second row corresponding to the two restraint equations. Table 5.0 Rs. 4 per unit of X1. The Cj row shows the profit made per unit of each variable. the first row represents the coefficients of our first equation and the second row represents the coefficients of our 164 .3 X2 1 2 Rs. At the extreme left-hand. under X1 we write all the coefficients of this variable. under S1 we write 1 and 0. the Cj row or the objective row is put above the variables row to remind us of how much profit we make for each item produced.4 X1 2 1 Rs.0 S2 0 1 (2) Restraint Equations: The two restraint equations are shown in the simplex tableau as follows: Quantity 30 24 X1 2 1 X2 1 2 S1 1 0 S2 0 1 Note that on the top we have first listed the products whose outputs we are determining. we write all the coefficients of this variable. under X1 we write 2/1. i. quantities of product in the mix) Variable columns Cj Rs. for example. under X2 we write 1 and 2. 0 per unit of S2. Rs. 3 above X2. 4 above X1. Rs.. Rs. Thus. Similarly. 3 per unit of X2.4 X1 Rs. 0 per unit of S1 and Rs.e.Rs.. for example.0 S1 Rs. viz. 0 above S1 and 0 above S2.0 S1 1 0 Rs.0 S2 Cj row Variable row Note that the coefficients in the objective equation are listed above the corresponding variables. X1. and under S2 we write 0 and 1.0 Product mix S1 S2 Quantity 30 24 Rs.

this origin (or corner point O) provides the starting point solution. The variables in the first solution are S1 and S2 (the slack variables representing unused capacity). if X1=0 and X2=0. (5) Zj row : The Zj may be defined as: “The Zj is the Cj for a row times the coefficient for that row within the tableau. the zero to the left of S2 row means that profit per unit of S2 is zero. This may better be understood by actually computing Zj row. In the quantity column we find the quantities of the variables that are in the solution: S1=30 hours available on Machine 1 S2=24 hours available on Machine 2 As the variables X1 and X2 do not appear. For example. to arrive at the Zj value for a particular column we first multiply each coefficient in the column by the Cj against the coefficient. they are equal to zero. (4) Cj column: We may now add Cj column at the left end. It may be noted that the product-mix column shows the variables in the solutions. note that no tables or chairs will be produced and all the capacity will be unused. Likewise.” In other words.second equation.. the zero appearing to the left of theS1 row means that profit per unit of S1 is zero. In other words. This shows the profit per unit for the variables S1 and S2.e. with no production and all unused capacity. We can see that if no tables or chairs are produced. This solution is the worst possible and is also known as trivial solution. i. At this point. we have already seen that all solutions to linear programming problems will be found amongst the corners of the feasible region. Under the simplex method. One such corner and in fact the most easily found corner is the origin. there will be no profit. then the first solution would be: X1=0 S1=30. (3) Product-mix column: Under the graphical method.2. in the product-mix. and then add up the products so obtained. 165 . summed by column. Finally. X2=0 S2=24 The first feasible solution then is shown in the initial simplex tableau 5. the starting solution will be the zero-profit solution. We have in this way simply rearranged the terms in the constraint equations to form the simplex tableau.

0 Rs.e. 4 Rs. 0 0 S2 0 1 Rs. So they are also to be multiplied: 0 X 24 = 0 Now. For example. 0 166 . 0+0=0 This is the value of Zj under the Quantity column. X2. 0 3 X2 1 2 Rs. The Cj against co-efficient 30 is 0. The values obtained for different variable shown in Cj-Zj row in initial simple table. It may be noted that this represents the total profit from this particular solution. 3 Rs.. the products are to be added. S1 and S2 could be obtained through this method. then Cj-Zj for X1=Rs.4.4 of profit to the solution and if its introduction causes no loss. (6) Cj-Zj Row Now Cj-Zj is the net profit that will occur from introducing –from adding-one unit of a variable to the production schedule or solution. 0 S1 S2 Zj Cj – Zj Quantity 30 24 0 4 X1 2 1 Rs. the Cj against co-efficient 24 is 0. 0 0 S1 1 0 Rs. So they are to be multiplied: 0 X 30 = 0 Again. Net income from the introduction of any variable could be obtained by following this procedure.Let us take the value in the Zj row under the Quantity column. i. 0 Rs. 5. zero in this case. 0 Product Mix Rs. if 1 unit of X1 adds Rs. The Zj values represent the amounts by which profit would be reduced if one unit of the respective added to the product mix.3 Completed Initial Simplex Tableau Cj Rs. The figures under this column are 30 and 24. The Zj value for the different variables viz X1.

As the S1 row has the smallest positive ratio it is called the replaced row. Entering Variable is one for which Cj – Zj value is the highest. divide each number in the quantity column that is 30 and 24 by the corresponding number in the pivot column. The first part of the new tableau to be developed is the X1 row. 4 for each unit of X1 added to the mix or by Rs. looking at this row one could determine whether any improved solution is possible. Therefore. optimum solution is reached when no positive number remain in the Cj – Zj row. a second simplex tableau can be developed. Firstly. (3) Developing Second Simplex Tableau: After choosing the entering and departing variable. A) Divide each number in the replaced row (S1 row) by the intersectional element (2) of the replaced row i. The X1 row of the new tableau is computed as follows. pivot number 30/2 = 15. The number in Cj – Zj row tell exactly which product will increase the profits most. On the other hand. III Developing Improved Solutions (1) Chose the Entering Variable: Whichever variable replaces S1 or S2 will be known as the entering variable. (2) Chose the Departing Variable: In order to determine which variable to be replaced following procedure has to follow. S1 row S2 row 30 hours/2hours per unit 24 hours/ 1 hour per unit = 15 units of X1 = 24 units of X2 Secondly. 3 for each unit of X2 added to the mix.By examining the initial numbers in the Cj – Zj row of the initial simplex tableau. Thus. select the row with the smallest ratio as the row to be replaced. This Cj – Zj value for any particular variable indicate the extent to which profit could be increased by adding 1 unit of that particular variable to the product mix. providing an improved solution. ½=½ ½=½ 0/2=0 167 . Hence.e. This row will be replaced in the next solution by 15 units of X1. we could find that total profit can be increased by Rs. Thus. As is seen in the table 5. 2/2=1.2 adding one unit of X 1 will add profit of Rs 4. X1 column is called optimum column or pivot column. This row is also known as the pivot row. a negative number in the Cj – Zj row would indicate the amount by which profit would decrease if one unit of the variable heading that column were added to the solution.

5). 0. the new X1 row would be: (15. -1/2. the new S2 row will be (9.5 indicates the existence of further improved solution. 1 ½. 1. we compute new values for the remaining row by using the formula shown in the 4 th column of the table5. Third simplex table has to develop by repeating the procedure discussed above (III Developing Improved Solutions). 0 X1 S2 Zj Cj – Zj Quantity 15 9 60 X1 1 0 Rs. 0). Table 5. ½. These values appeared in the second row of the table 5.5: Second Simplex Table Cj Rs. This procedure has to continue as long as there are/is positive number/s in the Cj-Zj row.4: Computation of New Values for the Rows other than Pivot Row. 60 from this solution or product mix.Thus.5. 2 -2 Zj value under quantity column was estimated to be Rs. 4) New Values for rows other than pivot row: To compute the second tableau. Element in old S2 row (1) Intersectional element of S2 row (2) Corresponding element in replacing row (3) New S2 = (Column 1 – (Column 2*Column3) (4) 24 1 15 9 1 1 1 0 2 1 ½ 1½ 0 1 ½ -1/2 1 1 0 1 Thus. 4 0 X2 1/2 S1 1/2 S2 0 1 Rs. Table 5.4. 168 . 0 0 1 1/2 Rs. 4 Rs. ½. 0 Product Mix Rs.60. 4 Rs. the producer could earn total profit of Rs. 0 Rs. 1). The existence of positive number in the Cj-Zj row of table 5. Thus. 3 Rs. 2 1 -1/2 Rs. These values appear in the second simplex tableau (table 5.

McGraw-Hill International Editions. Sales Variable Cost Fixed Cost Define the concept of profit What is slack variable? Explain the concept of break even point Distinguish between ‘Profiteering’ and ‘Profit-earning’ Explain the important steps involved in the simplex method of The following information is given by the cost accountant of X co. 30 and Rs. Only 800 units of chemicals and 200 units of compound are available in the firm. It can produce one unit P by using 2 units of chemicals and 1 unit of compound.7. Given this information estimate the optimum combination of P and Q to be produced by using the graphical method in order to produce and earn maximum profit. New Delhi-110002 169 . The profit per unit available to the firm is Rs. Dominick Salvatore: “Managerial Economics”. Similarly it could produce one unit of Q by using 1 unit of chemicals and 2 units of compound. 5. 5.5.8 References/ Suggested Readings 1. Singapore 2. 2. and Maheshwari K. Self Review Questions 1. Bangalore for 2005 i) Calculate BEP and Margin of Safety ii) The Effect of 10% increase in selling price 7.L: “Managerial Economics”. 100000 60000 30000 linear programming problem Ltd. 20 respectively. 3. Sultan Chand & Sons. 6. Varshney RL. 4. A firm producing either P or Q.

. Mumbai-400 004 170 .: “Managerial Economics”.Mithani : “Managerial Economics: Theory and Applications”. Margham Publications. Sankaran: “ Managerial Economics”. D. Madras 3. D.3. 5. Ghaziabad. Dwivedi.M. Himalaya Publishing House. Ltd. Vikas Publishing House Pvt. N.

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